Reading a Stock Prospectus
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Reading a Stock Prospectus
Reading a stock prospectus can be a tricky thing. The writers of these documents have a winding road to walk. On one hand, they must disclose all of the important elements of their business situation—even the unpleasant ones—to comply with Securities and Exchange Commission regulations and avoid potential shareholder lawsuits. On the other hand, they want to emphasize the strengths of the company and its growth prospects, while staying within the limits of what they are allowed to say in a prospectus. The result can be some very creative use of language in hopes of making the good stand out and making the bad seem, if not a little better, then at least somewhat ambiguous. Potential investors should read the prospectus carefully and seek out the answers to anything they do not understand.
Things To Know
- Look for experienced management that has a track record at publicly held companies.
- Find out where the proceeds of the stock offering will be invested.
The Risk factors section
While the Risk Factors section can be unsettling for a new investor to read, it is important to understand that all businesses face risk. In general, the company’s target market for its products and services should be large and growing. If it is not, the company could have trouble growing—especially if there are one or more major competitors also in the field. It’s also important to check that a company is not over-reliant on a small number of customers or suppliers.
Financial statements
The company’s financial statements should bear particular attention. Declining revenues, declining profit margins, and the buildup of liabilities greater than assets (without a convincing explanation from management) are all indications that the company may be floundering.
The "Use of Proceeds" section
The Use of Proceeds section is another place where potential trouble can surface. If a company is using a great majority of the proceeds of its new offering to pay off previous investors (such as its founding owners), you are really investing more in the company’s past than its future. Check to be sure that a large portion is being invested in specific efforts that will help the company grow.
The management section
Finally, look for experienced management, especially the presence of senior managers who have a track record at publicly held companies. It helps if their compensation includes stock options and other incentives that reward them for corporate growth.
This is just a partial list of all of the signals a prospectus can send. A full-service stockbroker or an investment advisor can be a tremendous resource in understanding how a company’s prospectus can give clues to its future performance. And some good news is in the offing for prospectus readers: the SEC is encouraging a move to "plain English" prospectuses that reduce legal jargon and make important information easier to read and understand.
