Pro-Forma Earnings Definition
Pro-Forma Earnings refers to the company’s income that is calculated in deviation from the compliance with the 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 the company can show a relatively positive picture of company’s financial statement.
In simple words, Pro-Forma earning exclude 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. and extraordinary items. It is used to show the positive aspect of earning. In this, the company’s earnings are not calculated according to Generally Accepted Accounting Principles (GAAP).
- It is also referred to as a projection of earnings that includes as a part of IPO, i.e., Initial Public OfferingInitial Public OfferingAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange..
- The company may exclude non-recurring items that usually do not occur as part of normal operations. Examples are asset impairmentsAsset ImpairmentsImpaired Assets are assets on the balance sheet whose carrying value on the books exceeds the market value (recoverable amount), and the loss is recognized on the company's income statement. Asset Impairment is commonly found in Balance Sheet items such as goodwill, long-term assets, inventory, and accounts receivable., 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.. A company’s intention 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. 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 analysis, and invest accordingly.
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Let us understand the same with a case study.
In 2001, Amazon.com released a Pro-Forma result of a quarter, excluding some expenses like write-downs of impaired assetsImpaired AssetsImpaired Assets are assets on the balance sheet whose carrying value on the books exceeds the market value (recoverable amount), and the loss is recognized on the company's income statement. Asset Impairment is commonly found in Balance Sheet items such as goodwill, long-term assets, inventory, and accounts receivable., 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. per GAAP was $170 million. Then controversy arose, which made the company develop reports per Pro-Forma standards and release reports. In late 2001 the Securities and Exchange Commission warned that if any company misled Pro-Forma, earnings could face civil fraud suits. In 2002 first action against this warning was taken over Trump Hotels and 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 AcquisitionsMergers And AcquisitionsMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion.. 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 dilutive and positively affect 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. can increase, but the value of merger companies is lower than the acquirer and target.
- Please note that incremental adjustments are an added value item created when two companies merge.
- For example, an E-commerce company merges with a courier company. This company is using its resources, which leads to increased profit and reduced costs. Through this merger, an e-commerce company can save its original courier cost, which was paid to third-party courier companies earlier.
How to Calculate Pro-Forma Earnings per Share (EPS)?
|Earning (in shares)
A calculation is as follows: –
The acquirer has total earnings of $ 6000 and shares outstanding of 3,000.
The target company being acquired has total earnings of $ 3,000.
Adjust is when the acquirer issues 700 new shares and hands them over to the target to complete the acquisition.
Pro Forma is the sum of all earnings divided by 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 or 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 Acquisitions 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 every expense company has faced, whereas Pro-Forma excludes non-recurring expenses
- GAAP cannot analyze long-term profit, whereas Pro-Forma helps one find a company’s long-term profit.
- When GAAP shows earnings in the negative, Pro-Forma earnings can be positive.
- GAAP cannot be manipulated expenses, whereas for Pro-Forma, earning the same can be manipulated.
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 they will not occur in the future.
- 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 for 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 company’s merger are one-time; hence, they are not considered 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 for a valuation of potential takeover targets.
- The company sometimes 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. and acquisition-related expenses. They expect an investor to consider these expenses as non-real and also consider earnings positively.
- These Earnings do not have any standard guidelines to follow.
- Some companies do not consider unsold inventories in a statement.
- These Earnings can be easily manipulated.
This article has been a guide to what Pro-Forma Earnings is. Here we discuss practical examples of Pro-Forma EPS calculations and the advantages and disadvantages. You may learn more about Financial Statements from the following articles –