If you read investing articles, especially ones for mutual funds, you may run across the term prospectus. And if you’re an investor, you’ve surely gotten these in the mail. More than likely, they’ve ended up in your recycle bin before you’ve opened the first page. But is trashing the prospectus really that harmless?
It can be. Why? Because knowing how to understand prospectuses is crucial for any investor so they can make an informed decision about buying or selling a stock or other security. Let’s go over what you might expect to see inside of a prospectus.
Purpose of a Prospectus
Before any company can try to raise money from selling securities, the SEC requires that company to prepare a document to inform the public and itself about the investment opportunity. This document is called the prospectus. Its purpose is to give investors all of the information they need so they can make an informed decision about purchasing a security. They are public records and can be requested from the company or the SEC. You can often find prospectuses online as well.
What’s in a Prospectus?
A prospectus contains both qualitative and quantitative information about a security. Most of the relative information you’ll need will be found near the front in the summary. The summary contains things like:
* Number of shares and the sale price
* The reasons why the company wants to raise money through selling securities.
* The expected risks the company faces regarding the success or failure of its plans with the money.
There are also additional portions that include things like:
* Names, ages, and short biographies of the corporate officers
* Financial statements for the company and an explanation of the numbers (so-called MD&A)
* What the business is and how it makes money
* Principal and selling shareholders
* Information about executive pay
* Who is underwriting the security
* Industry data
Depending on the investing model you prefer, different parts of the prospectus will be of greater interest. Quantitative people will jump straight to the financial statements. Qualitative people may want to know what the business plans in the future and how stable the management team is. Prospectuses are legal documents. If a company tells a lie or hides information in one, the SEC will come down on that business hard.
Prospectuses and IPOs
If you plan on investing in an IPO, you can get what’s called a preliminary prospectus. This will often have red letters on the front cover page. This is a preliminary document that the company files with the SEC, but until the IPO is finalized and open for sale it is to be considered a good guess at what the new business expects. Later, a finalized prospectus is created and filed that serves as the official one.
Most prospectuses are updated at least once a year, but mutual funds must do this due to the wide mix of securities they have in their portfolio. If you have one of these, you probably even received one in the mail. This often happens when people first start investing in a 401k.
If your goal is to be a serious investor, you can’t become afraid of reading a prospectus. Start by knowing what signals you like to see in a company’s business plans for a good buy, then dig into the prospectus to get the details you need before you pull the trigger.