Reading long and tedious financial documents such as the prospectus, which is created at a company's initial public offering to detail its prospects, isn't very exciting. But it can tell you a lot about a company's intentions. Because the prospectus is a legal declaration and must meet transparency standards, most companies include certain facts and statements to ensure investors aren't mislead in any way. For individual investors, the trick is to distinguish between statements that would likely appear in almost any prospectus and those statements that tell you about the distinct qualities of a company - the things that are most important. In this article, we show you how to make this distinction by looking at some prospectus excerpts.

Lessons in Interpretation
Let's walk through the prospectus (also called the 424 Form) of a company most of us are familiar with: Amazon.com Inc. As one of the first dotcoms to go public back in 1997, Amazon.com has a unique business model with unique risks. Given those facts, let's take a look at the warnings given in the prospectus.

Information contained in this Prospectus relative to markets for the company's products and trends in net sales, gross margin and anticipated expense levels, as well as other statements including words such as "anticipate," "believe," "plan," "estimate," "expect" and "intend" and other similar expressions, constitute forward-looking statements ...actual results of operations may differ materially from those contained in the forward-looking statements.

Interpretation - Every future-looking figure in the prospectus is only a projection. Therefore, there is no guarantee the company will meet all or even any of its targets for sales and profits. Because of the inherent uncertainty of these projections, investors must ask themselves whether they feel the assumptions are realistic. If, for example, Amazon projected to have over 80% of total online book sales by its second year of operations, you would want to question the basis for such an assumption and determine whether it is realistic. Predicting to capture such an outrageous portion of market sales is probably overly optimistic, and investors would want to be skeptical of such a forward-looking statement. Every prospectus is likely to have some statement saying that figures are based on events the company anticipates, but cannot guarantee. Most junior oil and gas producers, for example, have something in their prospectus acknowledging that their figures depend on whether exploration processes turn up any lucrative reserves.

Let's see what else Amazon.com Inc. says under "Risk Factors":

"...risks for the company include, but are not limited to, an evolving and unpredictable business model and the management of growth .... There can be no assurance that the company will be successful in addressing such risks, and the failure to do so could have a material adverse effect on the company's business, prospects, financial condition and results of operations."

Interpretation - Amazon.com faces substantial risks. If it fails to address these potential pitfalls - and this is very possible - there's a good chance that the company will go broke. Amazon tested uncharted waters with its business model, which is based on selling books to the masses online. (If you need to brush up on what a business model is, check out the article Getting to Know Business Models.) There was a great deal of uncertainty about whether people would actually stop buying from the brick-and-mortar stores and order books online. This is a great example of Amazon's prospectus telling us about a risk that is specific to the company. The above statement would not be found in many other prospectuses, as most companies tend to use tried and tested traditional business models. As a potential investor of Amazon.com, you must decide whether the risk of its business model has great potential or is just plain dangerous.

"The company believes that it will incur substantial operating losses for the foreseeable future, and that the rate at which such losses will be incurred will increase significantly from current levels. Although the company has experienced significant revenue growth in recent periods, such growth rates are not sustainable and will decrease in the future."

Interpretation - Amazon.com is losing money and will continue to lose money in the foreseeable future. Company growth rates will slow. Wow! This is another gold nugget in the prospectus, which is telling you outright that Amazon.com's profits will be negative for some time. This is definitely the type of thing you want to know before investing in the company. Other companies similar in nature to Amazon.com might also have prospectuses declaring loses, but that doesn't mean expected losses are not worrisome. If you are still interested in Amazon.com, you need to dig deeper to uncover why there are losses and little hope for future growth.

"The online commerce market, particularly over the Internet, is new, rapidly evolving and intensely competitive, which competition the company expects to intensify in the future. Barriers to entry are minimal, and current and new competitors can launch new sites at a relatively low cost."

Interpretation - Amazon.com Inc. operates in a highly competitive industry, which requires low costs for other companies to enter. The nature of the barriers to entry is unique to each industry, so the above statement offers some very valuable information. Low barriers to entry can lead to fierce competition: as soon as Amazon starts making any profit, it can expect a rival firm to spring up and attempt to take away valuable market share. There is little reason to believe that Amazon will be able to maintain any dominant position in its industry, adding additional risk (perhaps even danger) to investing in the company.

Conclusion
We know from Amazon's prospectus that its business model and profits at that time were uncertain, and that the competition is expected to be fierce. These are important factors to know, even if you are an investor who can handle the associated risks and who feels the company will persevere. Please note that this article is neither for nor against investment in Amazon.com. Its prospectus was used solely as a case study to point out items an investor might look for in the prospectus of any company.

Reading the prospectus means getting through some legalese and long cautionary statements that protect the company more than the investor. However, it's the legal nature of the prospectus that can give an investor some important information about prospective companies, namely the nature of their risks, prospects and industries. When reading a prospectus, you should pay more attention to information that is unique to the company than information that might apply to almost any public company.

by Investopedia Staff, (Contact Author | Biography)

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