Sep
11
2023
What is a Red Herring in IPOs?

What Is a Red Herring in IPOs?

By | Growing Wealth, invest, Investing | Comments Off on What Is a Red Herring in IPOs?

The term “red herring” usually refers to a misleading clue or statement, but when it comes to initial public offerings (IPOs) a red herring is a preliminary prospectus filed by a company that’s planning the IPO.

A red herring provides information on an IPO company, including coverage of its operations, total estimated IPO amount, management and competitive market standing. But it does not delve into the company’s financial information or reveal the share price or number of shares to be issued.

A red herring IPO stock has both investment and regulatory implications for newly minted IPO companies, and any investors who may be interested in steering some portfolio cash into these companies.

Key Points

•   A red herring in an IPO is a preliminary prospectus filed by a company that provides information on operations, estimated IPO amount, management, and market standing, but doesn’t include financial information.

•   A red herring combines both an IPO and an investment prospectus, and is a preliminary prospectus filed for review with the SEC.

•   The SEC reviews the red herring prospectus to make sure that all information is accurate before allowing the company to transition to the final investment prospectus phase.

•   Red herrings typically offer more pros than cons, but investors should understand the risks associated with trading IPO shares.

What Is an IPO Red Herring?

To better understand a red herring in IPOs, investors need to understand both the IPO and accompanying investment prospectus.

IPOs, Explained

An initial public offering is the process through which a private company goes public, with shares of the company’s stock available to the investing public. The term “initial public offering” simply refers to a new stock issuance on a public exchange, which allows corporations to raise money through the sale of company stock.


💡 Quick Tip: Access to IPO shares before they trade on public exchanges has usually been available only to large institutional investors. That’s changing now, and some brokerages offer pre-listing IPO investing to qualified investors.

Investment Prospectus, Explained

When a company transitions from a private company to public stock issuance, they must file a prospectus, a formal document sharing their financial picture with the Securities and Exchange Commission (SEC). That prospectus helps potential investors make good investment decisions based on the information included in the prospectus. A prospectus doesn’t just cover stocks — it’s also required for bonds and mutual funds.

Recommended: A Guide to Tech IPOs

Red Herring, Explained

A red herring combines both an IPO and an investment prospectus. A red herring in a preliminary prospectus filed before the actual prospectus is completed (it’s the first prospectus investors see). Companies file their red herring prospectus for review with the SEC.

As noted above, a red herring provides essential information on the company that’s about to debut in the public marketplace, including its operations, total estimated IPO amount, management and competitive market standing. Typically the red herring doesn’t get into the company’s financial information.

A traditional prospectus would normally include a stock’s share price and the number of shares made available to investors when the IPO commences, but a red herring prospectus does not. Still, the red herring prospectus contains a lot of the information that investors would want to know if they’re thinking about purchasing an IPO stock.

The more information that investors can collect about a stock, the better understanding they’ll have about whether it fits with their portfolio strategy and what type of investment risk they might need to consider. While all stocks include some degree of risk, IPO shares are particularly high-risk investments. Despite the media hype around many IPOs, which often focuses on big wins, the history of IPOs shows plenty of losses as well.

This is one reason why investors are typically asked to meet certain requirements in order to trade IPO shares through a brokerage.

How a Red Herring Works

Prospectuses are dynamic and change regularly, as new information comes forth. So, an investment prospectus will likely have multiple drafts before a final draft is released after SEC review.

In a red herring document, the prospectus is incomplete and noted as such, with the word “Red Herring” included on the prospectus cover. That disclaimer lets readers know not only that the prospectus is incomplete, but also that the company has filed for an upcoming IPO. The term “red herring” refers to both the initial prospectus and the subsequent drafts.

Additionally, a stock cannot complete its IPO until it fulfills the registration statement process, which is a primary reason why a red herring prospectus doesn’t include a stock price or the number of shares traded.

The SEC will review a red herring prospectus prior to its release to ensure that all information is accurate and that the document does not include any intentional discrepancies, falsehoods or misleading information.

Once regulators clear the registration statement, the company can go ahead and transition out of the red herring IPO phase and enter into the final investment prospectus phase. The time between the approval of the registration process and the time that it reaches its “effective date” (which clears the stock for public trading) is 15 days.

In clearing the IPO for stock market trading, the SEC does not hold any position on the stock, it simply confirms the necessary information is included in the final prospectus and that the information is accurate and compliant, based on U.S. securities law. Once the company gets through that hurdle they can continue moving through the IPO process.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Red Herring Pros and Cons

Red herring IPO prospectuses typically offer more “pros” than “cons,” but any investor looking to invest in an IPO stock should understand the benefits and investment risks when it comes to red herrings and in investing in IPOs.

Advantages

•   Useful overall information on the company. While investors won’t find any information on pricing or share amounts, they can review company history, operational strategies, management team, potential IPO amount, and market performance, among other company particulars.

•   Some financial data points. Red herring IPOs may provide valuable information about how a company plans to use proceeds from an IPO stock offering. Knowing, for example, that a company plans to use stock proceeds to grow the company or to pay down debts gives investors a better indication of company direction, which they can use to make more informed investment decisions.

•   Risk factors. Under a section known as “Risk Factors”, a soon-to-be publicly-traded company lists any potential risk factors that could curb performance and growth. Legal or compliance problems, abundant market competition, and frequent management turnover are just some of the potential risks included in a red herring IPO prospectus – and investors should factor those risks into any potential investment decision.

Disadvantages

•   No pricing data. The biggest drawback of red herring IPO prospectus is the fact that the documents don’t provide any guidance on IPO stock pricing or number of shares available. These are obviously critical components of any investment decision, but investors must wait until the registration statement process is fully complete before that data is available.

•   Shifting information. IPO company information can and does change from document version to version. Investors need to be diligent and stay apprised of all information on red herring prospectuses, from version to version, if they’re interested in an IPO stock.

•   Uncertainty. If government regulators cite deficiencies in a red herring prospectus they may half the IPO process until they’re addressed.

Recommended: SPAC IPO vs Traditional IPO: Pros and Cons of Investing in Each

The Takeaway

The red herring prospectus is the first version of a new IPO company prospectus, and may be the first detailed impression the investing public gets of an initial public offering.

By providing all the necessary information on a new publicly traded company (minus the opening share price and the number of shares available), a red herring prospectus can introduce investors to a new stock, which can provide much of the information necessary for investors to decide whether they’re interested in the company, and willing to assume the risks involved in trading IPO shares (if eligible).

Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

Photo credit: iStock/GOCMEN

SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $10 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Sep
11
2023
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Navigating the IPO Lock-up Period

By | Growing Wealth, invest, Investing | No Comments

Following an initial public offering, or IPO, many companies and investment bankers will tie your stock up in a lock-up period to stop you from cashing out too quickly and help keep the share price steady.

That may be frustrating if you’re an early employee and investor in a company that’s about to go public, as you may be expecting the value of your stock to skyrocket after the initial public offering, and were hoping to sell some shares. But lock-up periods serve a purpose, and stakeholders will need to know how to navigate them.

Key Points

•   An IPO lock-up period is a period after a company goes public during which some early employees and investors aren’t allowed to sell their shares.

•   Companies or investment banks self-impose the lock-up period contractually, usually lasting between 90 and 180 days.

•   The purpose of the lock-up period is to stop early investors from cashing out too quickly and maintain a steady share price.

•   Companies may also use the lock-up period to avoid flooding the market with shares and to prevent insider trading.

•   Regular investors may want to pay attention to the lock-up period when investing in IPOs, as it can affect the risk of investing in the company.

What Is an IPO Lock-up Period?

As a part of the IPO process, the IPO lock-up period is the length of time after a company goes public, during which some early employees or investors in the company aren’t allowed to sell their shares.

These restrictions are not mandated by the Securities and Exchange Commission (SEC), but rather are self-imposed contractually by companies or the investment banks that were hired to advise and manage the IPO process.

Lock-periods can be any length of time, but usually they’re between 90 and 180 days after the IPO. Companies may also decide to have multiple lock-up periods that end on different dates and allow different groups of people to sell their shares at different times.

How the IPO Lock-Up Period Works

Here’s an example of an IPO lock-up period: When one lock-up period ends company executives might be allowed to sell their shares, while a subsequent lock-up ending means regular employees can sell their shares.

What Does “Going Public” Mean?

When a company has an IPO, it is offering shares of the company for sale to the public stock market for the first time. The company is shifting at this point from a privately held company to a publicly traded company. This is the origin of the phrase “going public,” which you may have heard bandied around in reference to IPOs.

When a company is private, ownership is limited and can be tightly controlled. But when a company goes public, anyone can buy shares. But at this point there may be a lot of fingers in the pie already. Company founders, early employees, and even venture capitalists may already own shares or have stock options in the company.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

What Is IPO Underwriting?

Before a company goes public it often goes through an underwriting process in which an underwriter — usually an investment bank — advises the IPO process and helps come up with the business’ valuation. The most common way they do this is by agreeing to buy a company’s entire inventory of stock.

Then to alleviate the risk of holding all of this stock, the underwriter will allocate shares of the company to institutional investors before the IPO.

The underwriter will try to drum up so much interest in the stock that more people will want it than there are shares available. This will lead to the stock being oversubscribed, which will hopefully support its price when it hits the market.

Recommended: What Sets IPO Valuations

How IPO Lock-ups Get Used

A company or its underwriters might use the lock-up period as another tool to bolster the share price during the IPO.

Shares held by the investment bank or institutional investors can be sold during an initial public offering, but the shares held by company insiders — including founders, executives, employees, and venture capitalists — may be subject to a lock-up period.

With Silicon Valley tech startups in particular, a greater proportion of compensation may be paid out with equity options or restricted trading units. In order to avoid flooding the market with shares when employees exercise these contracts, the lock-ups restrictions mean that these shareholders are not able to sell their stock until this period is over.

Recommended: Guide to Tech IPOs

What Is the Purpose of a Lock-up Period?

Ensuring Share-Price Stability

Insiders, like employees and angel investors, can potentially own far more shares in a company than are initially available to the general public. The last thing a company wants during an IPO is to have these extra shares flood the market.

Since share price is set by supply and demand, extra shares can drive down the price of the stock. And that’s not a good look, especially when a company is trying to impress investors and raise capital.

Avoiding Insider Trading

Company insiders may face other restrictions beyond the lock-up period. That’s because they might have information that can help them predict how their own stock might do that is not available to the general public.

Though insider trading can be legal if properly controlled and documented, it is not legal when based on information the public doesn’t have yet. So, depending on when a lock-up period ends, company insiders may have to wait extra time before selling their shares.

For example, if a company is about to report its earnings around the same time a lock-up period is set to end, insiders may have to wait for that information to be public before they can sell any shares.

Public Image

Finally, lock-up periods can be a way for companies to keep up appearances. When those closest to the company hold their shares, it can signal to investors that they have confidence in the strength of the company.

If company insiders start to dump their stock, investors may get suspicious and be tempted to sell their shares as well. As demand falls, the price of the stock usually does, too.

Even if the insiders were trying to cash in their stocks for no other reason than simply wanting the money, public perceptions may change and damage the company’s reputation. The lock-up period may have an effect by keeping this from happening — at least while the newly public company gets off its feet.


💡 Quick Tip: Keen to invest in an initial public offering, or IPO? Be sure to check with your brokerage about what’s required. Typically IPO stock is available only to eligible investors.

What’s an Example of a Lock-up Period?

For example, let’s say Business X — a unicorn company — went public with an IPO in March 2022. The company used a system of multiple lock-ups with different expiration dates. The first lock-up expired in July 2022, and allowed early investors and insiders to sell up to 400 million shares of the company.

As new shares hit the market the stock dropped by as much as 5%, and it closed the day down just over 1%. A second lock-up expired in August 2022, allowing regular employees to sell their pre-IPO shares in the company. When this lock-up ended, employees were allowed to sell more than 780 million shares of Business X on the open market.

What Does the Lock-up Period Mean for Employees with Stock Options?

Restrictions imposed during a lock-up period usually apply to any stock options someone has been given as an employee before an IPO. Stock options are essentially an agreement with a company that allows its employees to buy stock in the company at a predetermined price.

The thinking behind this type of compensation is that the company is trying to align employees’ incentives with its own. Theoretically, by giving employees stock options, the employees will have an interest in seeing the company do well and increase in value.

There’s usually a vesting period before employees can exercise their stock options, during which the value of the stock can increase. At the end of the vesting period, employees are able to exercise their options, sell the stock, and keep the profits.

It’s possible that the company will issue stock options before it goes public. If stock options vest before the IPO, employees may have to wait until after the lock-up period to exercise their options. However, stocks may not vest until after the lock-up period, in which case the restrictions don’t have much bearing on the employee’s ability to exercise their stock options.

How Does the IPO Lock-Up Period Affect Investors?

When buying IPO stocks as a regular investor, you likely don’t have access to shares of a company before it goes public. Even so, you still might want to pay attention to the lock-up period. Investing in IPOs can be tricky and are generally considered risky.

The underwriters will probably do everything they can to make sure that stock prices go up when company shares hit the market. But in the end, no one really knows what will happen during an IPO.

Reading the IPO Prospectus

What’s more, investors interested in buying a stock that’s about to go public don’t really have much information to go on to help them figure out what kind of value they’re getting. When they’re private, companies don’t have to divulge very much information about their inner workings to the SEC.

However, before going public they will make documents available, including the Form S-1 and the red herring prospectus that can give investors some clues about a company’s business model and what they plan to do with the money they raise. Investors can also look at what happened when similar companies went public and whether they did well.

Waiting to Buy Until After Lock-ups End

This is all to say that with little idea of what a company’s stock will do when the company goes public, regular investors may want to hold off before they invest. Investors may even want to hold off until the lock-up period is over.

When the lock-up ends and insiders and employees can finally sell their shares, the stock price may experience some volatility as the new shares enter the market, potentially causing drops in a stock’s price.

Some investors may try to take advantage of the dip that can occur when a lock-up period ends. For example, if investors see that a company’s financial health is good during the first stages of its public life, they may use the expiration of the lock-up period as a chance to buy shares at a “discount.”

They may feel that if the stock’s fundamentals were good before the lock-up ended, the company is in good financial health and the stock should rebound. Timing the market, however, isn’t necessarily a good idea for all investors, especially those not used to taking a deep dive into the fundamentals of a company’s financials. It’s also not guaranteed to produce good results.

The Takeaway

Lock-up periods are agreed-upon periods between early investors and employees of a company and underwriting investment bankers during which selling of shares is prohibited. Having such stakeholders hold off on selling their shares can help the stock price of a newly public company stay more stable.

An initial public offering’s lock-up period can be hard to navigate. Yet, they can be really exciting for investors looking to get in on the ground floor and employees or insiders looking to cash in on their shares or stock options.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.
Claw Promotion: Customer must fund their Active Invest account with at least $10 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Sep
09
2023
What Are Assets Under Management (AUM) and Why Do They Matter?

What Are Assets Under Management (AUM) and Why Do They Matter?

By | Growing Wealth, invest, Investing | Comments Off on What Are Assets Under Management (AUM) and Why Do They Matter?

Assets under management (AUM) refers to the total market value of client funds managed by a person or a financial institution, such as financial advisory firms, brokerages, and mutual funds. The term may refer to funds managed for an individual client or total clients.

Typically, the higher an institution’s AUM, the higher their earnings, so it’s a measure they’re often looking to increase. That said, institutions have different meanings of AUM. So it’s important to have a good understanding of why AUM matters and how it is calculated before using it as a metric to decide whether or not to invest with a financial institution or a fund.

What Is AUM?

As mentioned, assets under management (AUM) refers to the total market value of client funds being managed by an individual or financial firm. To calculate AUM, a firm adds up the total value of the securities they manage, such as stocks, bonds, treasury notes, or futures contracts. However, there are some differences in the ways that organizations do this calculation.

For example, some banks might include cash deposits in AUM, while others may only include assets over which they have discretion. While the Securities and Exchange Commission (SEC) has rules about what can and cannot be included in AUM, different firms may interpret these rules differently.



💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Factors Impacting AUM

AUM, also known as funds under management, is not a static figure, and several factors that can cause the number to fluctuate.

Inflows and Outflows

As clients and investors increase or decrease the amount of money they have invested with a firm or in an investment fund, the total AUM will change. For example, if investors sell off shares of a mutual fund, AUM will likely start to fall. Or if a client at a financial advisory firm decides to use that firm to manage more of their money, that firm’s AUM will likely go up.

Market Shifts

Market shifts can also have a big impact on AUM, as the value of the securities in which the firm or fund has invested changes. For example, in a year when the stock market does poorly, assets managed by an advisory firm may decrease in value. During a market sell off, AUM often goes down for many firms. When markets do well, AUM will increase.

Dividends

If a firm or portfolio manages investments that pay dividends and the firm reinvests those dividends instead of distributing them, AUM can also grow.

A Moving Measure

The factors above mean that AUM is constantly in flux. How dramatic the fluctuations are depends on how many investors are shifting their money, as well as the types of investments AUM includes. For example, funds with a lot of volatile investments, such as stocks, may see broader swings in AUM than funds that hold more stable investments, such as bonds.

Recommended: Understanding How Bond Markets Work

Is a Larger AUM Better?

A larger AUM can be a plus or minus depending on circumstances. For banks, asset managers, and other financial institutions, larger AUM can be a sign of prestige and a measure of success. That’s because a larger AUM can determine things like compensation and bonuses for managers and how the company ranks against its peers. Larger AUM often also means higher revenues for the company.

However, larger AUM isn’t always a positive factor. For example, in actively managed mutual funds where a manager is looking to outperform a benchmark, large inflows of cash that boost AUM may hinder their goals. That’s because allocating large amounts of money quickly can be difficult to do without changing the price of the investments being bought or sold. To compensate for this issue, the fund may purchase other types of investment that cause it to shift away from its initial focus, a process called style drift.

Investors may consider the size of a fund as an indicator of the ease by which they can buy and sell shares in a mutual fund or an exchange-traded fund (ETF). High net assets and trading volumes suggest that the fund is highly liquid and investors should have no problem buying and selling shares at any time.

It can also be helpful to understand how a firm’s AUM has changed over time, and how they compare to peers.

Recommended: Top ETF 9 ETF Trends for 2023

Why is AUM Important?

AUM can have a big impact on individual investors’ decisions as they consider where to put their money. Companies often use their AUM as a selling point when they market themselves to clients. They contend that the larger the AUM, the more client interest and participation there is. In other words, AUM signals a vote of confidence in a firm. On the flip side, the lower the AUM, the fewer clients are interested in working with the institution or fund — theoretically anyway.

But AUM doesn’t always tell a full story. One firm with a handful of high-net-worth clients might have a higher AUM than a firm with dozens of clients with less savings. In this case, more clients actually chose to work with the firm with a lower AUM. So investors should be careful to look at other factors, such as investment approach, when determining who they want to work with.

Or a firm could decide to limit the number of investors it works with in order to provide more personalized service. In that case, the AUM might be lower, though the service could be better.

AUM can also have an impact on the investment fees that you pay. Many firms charge clients based on a percentage of their individual AUM, the money they hold with the firm personally. That percentage often goes down as the client’s AUM goes up.


💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

AUM Regulation

AUM may determine how financial advisors must comply with certain regulations. Firms with $100 million or more in AUM must register with the SEC, disclosing their AUM and a host of other information, each year.

In addition to information about AUM, Form ADV contains disclosures about disciplinary events involving advisors and their key personnel. Investors can access this information through the SEC’s Investment Advisor Public Disclosure website and use it to make informed decisions when choosing an advisor or money manager.

The Takeaway

As you choose funds to invest in — or firms to invest with — it’s important to understand their AUM. When it comes to investment funds, AUM can help you get a sense of the size of the fund and how easily you will be able to buy and sell shares.
When it comes to choosing an advisory firm or other financial institutions, AUM can help you understand the size of the firm.

That said, investors should consider a wide array of other factors, including the fees, fund’s performance and manager’s experience, when choosing investments and the professionals who can help manage their portfolios.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $10 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Sep
08
2023
What Is the Acid-Test Ratio?

What Is the Acid-Test Ratio?

By | Financial Independence, Growing Wealth, invest, Investing | Comments Off on What Is the Acid-Test Ratio?

The acid-test ratio (ATR) is one popular way to calculate a company’s liquidity, or the amount of cash or near-cash assets a company has to deal with immediate expenditures.

In comparing a company’s short-term assets against short-term liabilities, the acid-test ratio shows whether or not a company is well-financed. This ratio is subjective based on industry and the primary fundamentals of certain business models, but is a useful tool for gaining a basic understanding of a company’s liquidity level.

What Is the Acid Test Ratio?

An acid-test ratio (ATR), or quick ratio, is a comparison of a company’s most liquid short-term assets and short-term liabilities to calculate how much money it has to pay for immediate liabilities. In other words, it calculates how well a company can pay for short-term financial obligations with cash or assets that are easy to convert into cash.

The ATR disregards illiquid company financial assets such as real estate and inventory, instead focusing on the company’s ability to pay its current liabilities without needing to sell inventory or secure additional outside funding. This form of fundamental analysis is a more conservative measure than the current ratio, which includes all current assets when accounting for current liabilities.

A higher ATR indicates a company’s better liquidity and financial health, whereas a lower ratio indicates a company is more likely to struggle with paying immediate liabilities such as debts and other expenses. That being said, if a company takes longer to collect accounts receivable than usual or has current liabilities that are due but have no immediate payment needed, the acid-test ratio may not provide an accurate measurement of a company’s financial wellness.


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What Does the Acid-Test Ratio Tell You?

The acid-test ratio shows how financially capable a company is of paying short-term financial expenses. For beginner stock investors, calculating a company’s ATR may be an insightful fundamental analysis to look at a company’s financials.

An acid-test ratio of less than one indicates a company doesn’t hold sufficient liquid assets to cover current short-term liabilities and should be dealt with cautiously. It’s generally held that for most industries, the acid-test ratio should be greater than one.

However, a high ATR is not always best, as it could indicate an excess of idle cash that could otherwise be reinvested, returned to shareholders, or otherwise used productively for the business. For example, some technology companies generate substantial cash flows, which results in above-average acid-test ratios. While this indicates a healthy and productive business, some may advocate that shareholders who invest in the company should receive dividends from the company’s profits.

Recommended: How Do Stock Dividends Work?

If a company’s ATR is significantly lower than the current ratio, this indicates the company’s current assets largely depend on inventory. This isn’t necessarily a negative sign as some business models are inherently inventory-driven, such as retail stores, which typically have low acid-test ratios but aren’t necessarily in poor financial condition.

In such scenarios, it may make sense to consider other metrics such as inventory turnover. While acid-test ratios can vary widely based on industry, comparisons based on acid-test ratios can be more helpful when analyzing peer companies in the same industry.

How to Calculate the Acid-Test Ratio

The acid-test ratio is calculated as follows:
ATR = (Cash + Cash equivalents + Marketable securities + Current accounts receivables) ÷ Total current liabilities

To fully understand the ATR, it’s important to know the significance of each part of the equation:

•  Cash and Cash Equivalents: The most liquid current assets on a company’s balance sheets:

◦  Savings accounts

◦  CD with maturity of less than three months

◦  Treasury bills

•  Marketable Securities: Liquid financial instruments readily convertible into cash.

•  Accounts Receivables: Money owed to the company from providing goods and/or services to customers/clients.

•  Current Liabilities: Debts or obligations due within 12 months.

What Does the Numerator Mean in ATR?

The acid-test ratio’s numerator is ultimately a realistic assessment of the company’s liquid assets. This includes cash, cash equivalents, and short-term investments such as marketable securities, treasury bills, and very short-term deposits.

Accounts receivable are generally factored in as well, though there are industry-specific exceptions, such as construction, where accounts receivable may take significantly more time to recover than other industries — which may give the illusion the company’s financial condition is worse than in actuality.

Alternatively, the numerator can be calculated by subtracting illiquid assets, including inventory, from all current assets. This may negatively skew retail businesses’ financial condition because of the amount of inventory they typically hold. Additionally, subtract any other items that appear as assets on a balance sheet if they cannot be used to cover immediate-term liabilities such as prepayments, advances to supplies, and tax-deferred assets.

What Does the Denominator Mean in ATR?

The acid-test ratio’s denominator is composed of all current liabilities, defined as debts and financial obligations, due within 12 months.

Though time is not factored into the acid-test ratio formula, it can be a relevant variable. For example, if a company’s accounts payable are due sooner than its receivables are expected, the ratio may not factor for this time discrepancy that may arise, thus worsening the company’s financial health.

On the other hand, time can also be a benefit if accounts receivable are more frequent and regular than accounts payable, providing more frequent cash infusions to a possible undersupply of short-term assets.

Pros and Cons of the Acid-Test Ratio

When it comes to assessing the usefulness and accuracy of the ATR, there are both pros and cons.

Pros

1.   It removes inventory from calculation, providing a more accurate picture of the company’s liquidity position.

2.   It removes Bank Overdraft and Cash Credit from current liabilities because they are usually secured by inventory, thus making the ratio more tangible.

3.   It’s not handicapped, as there is no need for valuation of inventory.

Cons

1.   The ATR is not the sole determinant of a company’s liquidity. It’s commonly paired with other liquidity formulas such as current ratio or cash flow ratio to form a more complete and accurate assessment of a company’s financial condition and liquidity status.

2.   ATR disregards inventory in calculating the ratio because inventory isn’t generally considered a liquid asset. However, for businesses that are able to quickly sell their inventory at market price, inventory would qualify as a near-cash asset.

3.   It doesn’t provide information regarding time frame and degree of cash flows—fundamental factors in accurately calculating a company’s ability to satisfy its accounts payable when due.

4.   It assumes accounts receivable are readily available, which may not be as easy as anticipated.

The Takeaway

The Acid-test ratio is an insightful and relatively accurate analysis of a company’s liquidity status. It’s one of the many methods for analyzing businesses, reviewing business fundamentals and company financials.

By comparing the company’s cash on-hand, near-cash equivalents, and easily convertible short-term assets against its current liabilities, one can surmise how readily prepared a company is to satisfy short-term liabilities. The formula determines how liquid a company is based on a variety of assets and expected cash flows versus expected accounts payable. This ratio, though not designed to be used solely, ultimately determines if a company is well capitalized or under financial strain. For an investor, this can help shine a light on whether or not a company may or may not be a promising investment.

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For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

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SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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2023
Understanding Diluted EPS

Understanding Diluted EPS

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Understanding Diluted EPS

Diluted earnings per share (EPS) is a measure of earnings per share that includes a company’s convertible securities. Convertible, or dilutive, securities are stocks or bonds that could potentially become common shares. Basic earnings per share only considers existing common shares.

Diluted EPS, then, includes in its calculation the factor of convertible bondholders, convertible preferred stockholders, and options holders potentially deciding to turn their securities into common shares. If this were to happen, the number of shares outstanding would increase, with earnings staying the same, resulting in lower earnings per share. Diluted EPS will therefore tend to be lower than basic EPS.

Basic vs. Diluted EPS

What is diluted earnings per share, and how does it differ from basic EPS? Simply put, basic EPS tends to be a higher number than diluted EPS. Basic EPS doesn’t factor in the existence of convertible securities of the impact if they were to be converted into common shares.

Instead, the most basic calculation of earnings per share only takes a company’s net income minus any preferred stock dividends and divides that number by the number of shares outstanding. Convertible securities aren’t factored into the equation.

Because of this, sometimes it’s beneficial to look at a calculation of earnings per share that assumes all possible common shares have been brought into being through existing convertible securities. Doing so gives investors a more realistic view of earnings while assuring no future surprises.

Imagine an investor doing all their homework on the fundamental analysis of a company using only basic earnings per share. EPS, which measures the value that a company delivers to individual shareholders, might look high and the stock pays a good dividend, so the investor might decide the stock is a good one to buy.

But then she learns that the company has been issuing convertible bonds to raise capital and giving new employees stock options to make working there more attractive.

All of a sudden, for some reason, bondholders decide to convert their bonds to common shares, and employees decide to exercise their stock options.

Now this investor’s shares have been diluted, since a bunch of new shares have popped into existence practically overnight. As a result, earnings per share have decreased, and dividends likely have done the same (because the same dividends now have to be paid out to additional shareholders).

If our imaginary investor had used diluted EPS in her calculations, she could have prepared for this kind of scenario at some point. But because this make-believe company created the potential for its stock to be diluted by issuing convertible securities, basic EPS did not provide the full picture.


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How to Calculate Diluted EPS

The formula for diluted EPS is a company’s net income minus any preferred stock dividends, divided by the company’s average outstanding shares minus its dilutive shares. Or:

Diluted EPS = (Net Income – Preferred Stock Dividends)/(Average Outstanding Shares – Dilutive Shares)

The diluted EPS formula is calculating the amount of earnings per share there would be if dilutive shares were to become common shares. The formula is exactly the same as that of calculating basic EPS, but with one important extra step – adding the number of dilutive shares to the number of average outstanding shares (in the bottom half of the equation).

The sum of both existing common shares and the possible dilutive shares creates a larger number on the bottom half of the equation, while the top half remains the same.

Therefore, diluted EPS tends to be lower than basic EPS, as the company’s net income (minus preferred stock dividends) is being divided by a larger number of shares.

For example, let’s say a company makes $1,000,000 in net income and pays no dividend. There are 800,000 common shares outstanding, 100,000 call options, and 100,000 convertible preferred shares.

The diluted EPS formula would yield a result of $1.00 per share in this example, as we would be dividing 1,000,000 dollars in net income by 1,000,000 total potential shares.

Basic EPS, on the other hand, would be calculated as $1,000,000 divided by the 800,000 current shares, yielding a result of $1.25 per share.

While it’s not difficult to calculate EPS and diluted EPS, many companies share the figures with investors in their earnings reports.

Recommended: What You Should Know About Earnings Calls

Why Is Diluted EPS Important?

Diluted EPS reveals what a company’s earnings per share could look like if holders of convertible securities were to decide to exercise their right to hold common shares, and it’s an important consideration during an investor’s analysis of a stock.

Since companies often issue convertible securities like stock options, convertible bonds, convertible preferred shares, a company’s earnings per share could appear higher than reality when not factoring in the potential for dilution.

Convertible securities might be held by people inside or outside of the company, and they may not be turned into shares anytime soon. But what happens when everyone decides to turn in their convertible securities for shares?

For example, if a company’s stock were to rise in price suddenly, and the company had paid several of its employees bonuses in the form of stock options, those employees might choose to exercise those options.

Now there are more common shares than before, but earnings have not increased. Therefore, in a theoretical example like this, earnings per share will have decreased.

A company issuing employee stock options isn’t always a negative thing, however. If the options keep high-quality employees, the result could be positive for the company over the long run. Using options also reduces expenses that come from paying employee salaries, which could free up capital to help the company grow.

Diluted EPS provides a more conservative earnings per share number since it shows what EPS would be in the event of more new shares coming into existence. Basic EPS could appear to be deceivingly high because it doesn’t calculate for this possibility, so it could be a less reliable indicator of when to buy, sell, or hold a stock.

Of course, there might also be times when diluted EPS is unnecessary. Young companies that are still small and growing might not have had the chance to issue any convertible securities yet, so earnings per share might look the same either way.

The Takeaway

Diluted EPS is a measurement of earnings per share that factors in the potential stock dilution that occurs when convertible securities are converted to common shares. Understanding diluted EPS is important so that investors don’t get caught off guard in the event of new common shares being created through the conversion of securities such as stock options, stock warrants, convertible bonds and convertible preferred shares.

When this happens, earnings per share decline, and those who had only been looking at basic EPS in an attempt to determine the profitability of a company will find they made a miscalculation. In some cases, the difference between basic and diluted EPS might not be that different. If a company hasn’t issued convertible securities, or has issued very few convertible securities, then not much dilution would be possible.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $10 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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