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Investing Basics - November 5th, 2004
http://www.investopedia.com
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Table of Contents:
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1. Term of the Week: Earnout
2. Feature Article: Surviving Bear Country
3. Q&A: What is earnings management?
4. Q&A: What are the differences between chapter 7 and
chapter 11 bankruptcy?
5. Test Your Financial Knowledge
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Term of the Week: Ghosting
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A contractual provision stating that the seller of a business
is to obtain additional future compensation based on the business
achieving certain future financial goals.
Investopedia Says:
The financial goals are usually stated as a percentage of
gross sales or earnings.
Say an entrepreneur selling a business is asking $2,000,000
based on projected earnings, but the buyer is willing to pay
only $1,000,000 based on historical performance.
An earnout provision structures the deal so that the entrepreneur
receives more than the buyer's offer only if the business achieves
a certain level of earnings. The exact numbers would depend
upon the business, but in this example a simplified provision
might set the purchase price at $1,000,000 plus 5% of gross
sales over the next three years. The earnout thereby helps
eliminate uncertainty for the buyer.
For related terms and articles, please go to:
http://www.investopedia.com/terms/e/earnout.asp
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Feature Article: Surviving Bear Country
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A bear market refers to a decline in stock prices of at least
15%-20%, coupled with pessimistic sentiment underlying the market.
Clearly no stock investor looks forward to these periods.
Don't despair, there is hope! In this article we will walk
you through some of the most important investment strategies
and mindsets that one can use to limit losses or even make
gains while the stock market is performing in such a manner.
Read this article, go to:
http://www.investopedia.com/articles/01/031401.asp
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What is earnings management?
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Before diving into what earnings management is it is important
to have a solid understanding of what we are talking about when
we are referring to earnings. Earnings are the profits of a
company. Investors and analysts look to earnings to determine
the attractiveness of a particular stock. Companies with poor
earnings prospects will typically have lower share prices that
those with good prospects. Remember that how much profit a
company is able to generate in the future plays a very important
role in determining a stock's price.
That said, earnings management is a strategy with which the
management of a company purposefully manipulates the company's
earnings so the figures match a pre-determined target. This
practice is carried out for the purpose of income smoothing.
Thus, rather than having years of exceptionally good or bad
earnings, companies will try to keep the figures relatively
stable by adding and removing cash from reserve accounts
(known colloquially as "cookie jar" accounts).
Abusive earnings management is deemed by the SEC to be "a material
and intentional misrepresentation of results". When income smoothing
becomes excessive, the SEC may issue fines. Unfortunately, there's
not much individual investors can do. Accounting laws are extremely
complex for large corporations, which makes it very difficult for
regular investors to pick up on accounting scandals before they happen.
Although the complexity of the different methods by which managers
can smooth earnings is very confusing, the important thing to
remember is the driving force behind managing earnings is to meet
a pre-specified target (often an analysts' consensus on earnings).
As Warren Buffett has been famously quoted to say, "Managers that
always promise to 'make the numbers' will at some point be tempted
to make up the numbers".
For more on earnings management check out these articles:
"Earnings: Quality Means Everything"
http://www.investopedia.com/articles/02/103002.asp
"The Tricks and Treats of Pro Forma Earnings"
http://www.investopedia.com/articles/01/103101.asp
For a better understanding of how stock prices are determined, see
our "Stocks Basics Tutorial":
http://www.investopedia.com/university/stocks/
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What are the differences between chapter 7 and chapter 11 bankruptcy?
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Chapter 7 bankruptcy is sometimes also called liquidation
bankruptcy. Firms experiencing this form of bankruptcy are
past the stage of reorganization and must sell off any
un-exempt assets to pay creditors. In chapter 7 the
creditors collect their debts according to how they
lent out the money to the firm (also referred to as the
"absolute priority"). A trustee is appointed, who ensures
that any assets that are secured are sold and that the
proceeds are paid to the specific creditors. For example,
secured debt would be loans issued by banks or institutions
based upon the value of a specific asset. Whatever assets
and residual cash remain after all secured creditors are
paid are pooled together and paid to any outstanding creditors
with unsecured loans: e.g., bondholders and preferred shareholders.
Chapter 11 bankruptcy can also be called rehabilitation
bankruptcy. It's much more involved than chapter 7 as it
allows the firm the opportunity to reorganize its debt and
to try to re-emerge as a healthy organization. What this
means is that the firm will contact its creditors in an
attempt to change the terms on the loan such as the interest
rate and dollar value of payments. Like its cousin,
chapter 11 requires that a trustee be appointed; however,
rather than selling off all assets to pay back creditors,
the trustee supervises the assets of the debtor and allows
business to continue. It's important to note that debt is
not absolved in chapter 11, as the restructuring only
changes the terms of the debt and the firm must continue
to pay it back through future earnings.
If a company is successful in chapter 11 it will typically
be expected to continue operating in an efficient manner
with its newly structured debt. If it is not successful, then
it will file for chapter 7 and liquidate. In both instances,
common shareholders will most likely see little return on their
investment (if anything).
To learn more about bankruptcy check out these articles:
"What Does Bankruptcy Mean to Investors?"
http://www.investopedia.com/articles/01/120501.asp
"Z Marks the End"
http://www.investopedia.com/articles/fundamental/04/021104.asp
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Test Your Financial Knowledge
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Q. At what price per share did Microsoft have its
Initial Public Offering in 1986?
a) $0.50
b) $1.00
c) $2.00
d) $5.00
e) $21.00
To answer this question, please visit the homepage:
http://www.investopedia.com/
Have a great week!
The Investopedia Staff
http://www.investopedia.com
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