The due diligence acid test

You’re putting the final touches on your financial model. You’re practically done valuing the company. Following are a few questions that will ensure that your valuation assumptions are robust. Because let’s not forget, valuation is merely a tool. Its ultimate value essentially rests on the quality of the assumptions which it is fed. So here we go:

  • Have you mostly relied on the target company (or worse, on its advisors) to inform your assessment of the target’s risk and opportunities? Or have you built your own, proprietary view of the target’s potential by conducting your own extensive strategic analysis and by tapping into your own, unbiased information sources (such as suppliers, competitors, ex-employees, expert networks, clients, ex-clients, etc.)?
  • Have you limited yourself to a “market and industry outlook”  analysis? Or have you conducted a thorough competitive analysis in which you’ve gone much deeper and clearly compared and ranked all the relevant players using the relevant criteria ?
  • Along the same lines, have you identified the likely predictors of future market success, based on demand trends and likely shifts in the competitive landscape?
  • Are you sure that you are avoiding “confirmation bias”, which is  the tendency to ignore any information that does not support the investment decision that you’ve already made (whether consciously or not) ? To make sure that you’ve avoided this bias, have you played the “bulls and bears” game ? That is, have you made sure that someone on the investment team has purposefully taken opposite sides of the deal champion and has identified at least 5 good reasons to NOT pursue an opportunity? Has the team been able to satisfactorily defuse each of these reasons to NOT proceed?
  • Have you done a minimum amount of “war gaming” or competitive simulation? Have you assessed the robustness of your investment thesis under different scenarios that could unfold after the transaction (especially consolidation amongst customers, suppliers or competitors)? Of course, this assumes that you have a well-researched profile on each competitor, its management style, its shareholding structure, its most likely strategic direction, etc. You do have such information, right ?
  • Finally, have you taken a step back to honestly ask yourself if you were forgetting any crucial question in your analysis ?

There is nothing static in the investment game. Like in most competitive endeavors, your chances of winning are based on your ability to properly read all players and anticipate their likely actions and reactions. Avoid the common traps. Describing a situation does not mean that you understand it. And without a reasonable understanding of that situation, you will be unable to intelligently anticipate likely developments. And if you can’t reasonably anticipate, you should not invest.

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