When a company decides to go public, it files a prospectus with the Securities and Exchange Commission. This long but important report provides potential investors with the information they need to make a smart decision about buying shares during an initial public offering. Here is a basic guide to reading a prospectus:
A prospectus serves various purposes for both companies and investors. Prospective investors use the prospectus to get a sense of the company's business plan once it goes public, its mission and its financial situation. If you are looking to invest in a company that is already publicly traded, other SEC filings like the annual report will provide the same information that is found in the prospectus.
The prospectus also serves as a legal document, as it provides written proof that the proper information was made available to you. Prospectus reports are no easy read, however, and thoroughly weeding through the legal jargon may require the assistance of a trusted adviser.
Parts of a prospectus
A prospectus organizes information under certain headings, much like book chapters. According to the SEC, the prospectus has information about fees and expenses, investment objectives, risks and pricing. The document begins with basic details about the company, whether it is the preliminary or final prospectus, and a summary of the information within the prospectus. The general details are followed by disclosure of risks disclosure and a description of the use of proceeds, which explains how your capital will be used and gives insight as to why the company has decided to go public.
Company finances are presented in various forms, including a capitalization table that illustrates the company's assets before and after the offering. A dividend policy lets you know if the stock is income or growth oriented, which affects whether it pays dividends. A section on management reveals how executives feel about the company's current and future performance. In this section, you can review trends in the company's earnings, revenue and expenses, so make sure to pay close attention.
Understanding a company's value
Two of the best indicators for value are future opportunity and stock price. Look at whether the offering price is high relative to these valuations; you may find yourself over-paying for shares. On the other hand, a shockingly low price may be a red flag.
Kevin Cope, author of "Seeing the Big Picture: Business Acumen to Build Your Credibility, Career, and Company," says you should look at the company's sales and profit to anticipate future growth. Note that growth and future opportunity come in all shapes and sizes. Cope says if a company is going out of business, then its value may simply be the assets it currently has, such as buildings, equipment and inventory.
Reading the risk factors
Make sure you account for the age and track record of the company, how much capital the company owns, and quality of the management, when weighing the risks of investing in the company. Other risk factors are listed in the first few pages of a prospectus.
"Risks could include social trends, macroeconomic conditions, competitors, technological advances," says Cope. "For example, investing in even a profitable book store today could represent significant risk, given the market shift from print to e-readers."
Spotting the red flags
Investments always involve a certain degree of risk, but reading the prospectus can help you avoid buying shares of a disastrous IPO. Compare the company's original worth to its recent progress, and try to figure out whether you are being asked to pay more than the original investors.
Keep an eye out for excessively high executive compensation. Questionable deals and transactions in the company's past might point to misallocation of assets. Sudden changes in accounting methods and unaudited financials also entail further investigation.
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