Reading long and tedious financial documents such as the prospectus, which is created at a company's initial public offering (IPO) 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 misled in any way. For individual investors, the trick is to distinguish between statements that would likely appear in almost any prospectus and statements that tell you about the distinct qualities of a company—which are most important. In this article, we show you how to make this distinction.
Lessons in Interpretation
Let's walk through a sample prospectus (also called the 424 Form) for an online retailer. We'll start with the "Risk Factors" section, which contains important information for investors.
The Prospectus Says: "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 forward-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 stated in its original prospectus that it would have a certain percentage of total online book sales within the year, investors would need to question the basis for such an assumption and determine whether it is realistic. Predicting the ability to capture a high 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 the company says under "Risk Factors":
The Prospectus Says: "... 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: This company 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.
Using Amazon as an example again, it tested uncharted waters with its business model, which is based on selling books to the masses online. In the beginning, there was a great deal of uncertainty about whether people would actually stop buying from brick-and-mortar stores and order books online. The above statement would be likely be associated with a company that has a new business model, such as Amazon. It is not likely to be found in many other prospectuses, as most companies tend to use tried-and-tested business models. Therefore, as a potential investor reading such a prospectus, you must decide whether the risk of its business model has great potential or is just plain dangerous.
The Prospectus Says: "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: According to the prospectus, this company is losing money and will continue to lose money in the foreseeable future. Company growth rates will slow.
If you find such a statement in a company's prospectus, this is a true gold nugget. It tells you that profits will be negative for some time. This is definitely the type of thing you want to know before investing in a company. If you are still interested in investing in a company that is currently unprofitable, you need to dig deeper to uncover why there are losses and determine what it would take for the company to turn this around.
The Prospectus Says: "This market 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: The prospectus is telling us that this company operates in a highly competitive industry, and one that is cheap and relatively easy for new players 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. If this company manages to turn a profit, it can expect a rival firm to spring up and attempt to take away valuable market share. This creates additional risk for investors.
The Bottom Line
We know from the portions of prospectus presented here that this company's business model and profits are 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 feels the company will persevere.
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.