Pro-Forma Earnings Definition
Pro-Forma Earnings refers to the company’s income that is calculated in deviation from the compliance with Generally Accepted Accounting Principle as it does not take into account non-recurring items such as extraordinary items like loss due to fire, restructuring expenses, etc. so that relatively positive picture of company’s financial statement can be shown by the company.
In simple words, Pro-Forma earning refers to earning that excludes non-recurring items like restructuring chargesNon-recurring Items Like Restructuring ChargesNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off.read more, extraordinary items. In this, the company’s earnings are not calculated according to Generally Accepted Accounting Principles (GAAP). It is used to show the positive aspect of earning.
- It is also referred to as projection of earning that includes as a part of IPO, i.e., Initial Public OfferingInitial Public OfferingInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes.read more.
- The company may exclude item that is non-recurring or that usually not occurs as a part of normal operations. Examples are asset impairments, obsolete inventories, restructuring charges, and extraordinary itemsExtraordinary ItemsExtraordinary Items refer to those events which are considered to be unusual by the company as they are infrequent in nature. The gains or losses arising out of these items are disclosed separately in the financial statement of the company.read more. The intention of a company through these is to create a clear picture of its normal profitabilityNormal ProfitabilityThe term "normal profit" is used when the profit is zero after accounting for both the implicit and explicit expenses, as well as the overall opportunity costs. It happens when all of the resources have been used to their full potential and cannot be put to better use.read more and show it to investors.
- Moreover, some companies misuse this and exclude items that should generally include as per GAAP. An investor should take precautions, do fundamental analyses, and invest accordingly.
Case Study
Let us understand the same with a case study.
source: amazon.com
In 2001, Amazon.com released it a Pro-Forma result of a quarter, which was excluding some expenses like write-downs of impaired assets, interest expenses, and losses on equity investments.
As per Amazon.com, Pro-Forma operating loss narrowed to $27 million for the third quarter, whereas net lossNet LossNet loss or net operating loss refers to the excess of the expenses incurred over the income generated in a given accounting period. It is evaluated as the difference between revenues and expenses and recorded as a liability in the balance sheet.read more as per GAAP was at $170 million. Then controversy arose, which made the company develop reports as per standards of Pro-Forma and release report. In late 2001 the Securities and Exchange Commission issued a warning if any company misleads Pro-Forma earnings could face civil fraud suits. In 2002 first action against this warning was taken over Trump Hotels, Casino Resorts.
What is Pro-forma EPS?
It also helps to find Pro-Forma EPS. This calculation is based on the normalized net income that excludes non-recurring expenses. Pro-Forma EPS aims to find the stream of earnings from operations, which can be used to forecast future EPS.
Pro-forma EPS is very helpful in Mergers and Acquisitions; wherein it adds the target net income and any additional synergies or incremental adjustments to the numerator while adding new shares issued due to acquisition to the denominator.
Pro-Forma EPS Formula
- Pro-Forma EPS is used by acquiring a company to determine the financial outcome they will have by acquiring the target or merger with the target. It also allows the acquirer to determine whether this transaction will be accretive or dilute and have a positive effect on EPS. This situation can also arise where Earnings Per ShareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more can increase, but the value of merger companies is lower than the acquirer and target.
- Please note Incremental Adjustment are an added value item that is created when two companies merge.
- For example, an E-commerce company merges with the courier company. Through this merger, an e-commerce company can save its original courier cost, which was paid to third party courier companies earlier. This company is using its resources, which leads to an increase in profit and reduce costs.
How to Calculate Pro-Forma Earnings per Share (EPS)?
| Particulars | Acquirer | Target | Adjust | Pro Forma |
|---|---|---|---|---|
| Earnings ($) | $6000 | 3000 | 9000 | |
| Earning (in shares) | 3000 | 700 | 3700 | |
| EPS ($/Share) | $2 | 2.43 | ||
| Accertion/Dilution | 21.50% |
A calculation is as follows: –
The acquirer has total earnings of $ 6000 and shares outstanding of 3,000.
EPS =6000/3000
The target company being acquired has total earnings of $ 3,000.
Adjust is the acquirer issues 700 new shares and handing them over to the target to complete the acquisition.
Pro Forma is the sum of all earning divided by the sum of all shares outstanding to get Pro Forma EPS.
- Pro Forma EPS = (Acquirer’s Net Income + Target’s Net Income)/(Acquirer’s shares outstanding + New Shares Issued)
- = (6,000+3,000)/(3,000+700)
Pro Forma EMS will be:
- Accretion/ Dilution is the percentage in EPS after the transaction of before.
- Accretion/ Dilution= (2.43-2)/2*100
- Accretion/ Dilution
AccretionAccretionAccretion primarily means gradual or incremental growth. However, with respect to finance, it has the following technical meaning: 1) Bond Markets 2) Merger and Acquisitionsread more means positive, and dilution means negative.
You can download this Excel Template Here:- ProForma Earnings EPS Calculations Excel Template
GAAP vs. Pro-Forma Financial Statements
- GAAP gives details of each, and every expense company had faced whereas Pro-Forma excludes non-recurring expenses
- GAAP unable to analyze long-term profit, whereas Pro-Forma helps one to find the long-term profit of a company.
- When GAAP show earning in negative Pro-Forma earning can be positive.
- GAAP cannot be manipulated expenses, whereas for Pro-Forma, earning the same can be manipulated.
Uses
Pro-Forma Earnings Statement provides a better look at the performance and value of a company’s core business. Mostly non-recurring business events can be excluded because it will be expected that it will not occur in the future.
Advantages
- Pro-Forma EPS also gives an investor a clear picture of company operations. For some companies, it provides an accurate view of financial performance and looks out of a company.
- Considering non-recurring expenses affect investor’s view, but these expenses are of short-term and long-term profit earning need to be calculated through Pro-Forma EPS in which these expenses are not considered and help to analyze long-term profit. Example: Charges of a merger of a company are one time; hence, not consider in Pro-Forma EPS.
- These Earnings are a useful tool to identify the company’s core value driver and analyze changing trends within company operation, which later could be used to a valuation of potential takeover targets.
Disadvantages
- Company sometime excludes things like stock-based compensationStock-based CompensationStock-based compensation also called share-based compensation refers to the rewards given by the company to its employees by way of giving them the equity ownership rights in the company with the motive of aligning the interest of the management, shareholders and the employees of the company.read more and acquisition-related expense, and they expect an investor to consider these expenses as non-real and also consider earnings in positive.
- These Earnings does not have any standard guideline to follow.
- Some companies do not consider unsold inventories in a statement.
- These Earnings can be easily manipulated.
Recommended Articles
This article has been a guide to what is Pro-Forma Earnings. Here we discuss practical examples of Pro-Forma EPS calculations along with the advantages and disadvantages. You may learn more about Financial Statements from the following articles –
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