What it is:
Due diligence is the careful, thorough evaluation of a potential investment, whether on a corporate or individual level.
How it works (Example):
For individual investors, due diligence often means studying annual reports, SEC filings, and any other relevant information about a company and its securities. The objective is to verify the material facts related to the purchase of the investment, as well as to understand whether the investment fits an individuals return requirements, risk tolerance, income needs, and asset allocation goals.
An individual's due diligence might include reading the company’s last two or three annual reports, several recent 10-Qs, and any independent research they could find. In doing so, they would develop a sense of where Company XYZ is headed, what market factors might affect the stock’s price, and how volatile the stock is. This in turn might give them guidance about whether the investment is right for you, and if so, the size and timing of their investment.
In a merger scenario, due diligence often involves a team of people specially tasked with reviewing and verifying every aspect of an investment in another company. In many cases, this team might include lawyers, accountants, and investment bankers.
Why it Matters:
Due diligence helps people and companies understand the nature of an investment, the risks of an investment, and how (or whether) an investment fits into a particular portfolio. Due diligence isn’t just good sense, it’s a duty investors owe to themselves -- doing this sort of "homework" on a potential investment is often essential to making prudent investment decisions.