Pro-forma Earnings per Share (EPS)
Strips down non-recurring costs to provide a better picture of company profits
What are Pro-forma Earnings per Share (EPS)?
Pro-forma EPS strips down non-recurring costs to provide a better picture of company profits. It aims to isolate earnings from operations. This results in a more positive EPS forecast, in turn showing a company’s true long-term profitability for investors.
This action is usually taken internally to gauge earnings performance, but it is also useful when a company is trying to attract investors through a roadshow before deciding to IPO.
Furthermore, one of its key applications is related to Mergers and Acquisitions (M&A), where the acquiring company can determine how its EPS changes after purchasing or merging with the target company.
However, one issue with the Pro-forma EPS calculation is that it does not adhere to generally accepted accounting principles (GAAP).
Key Takeaways
- Pro-forma EPS focuses on areas where earnings are generated. This is done by removing one-time costs that might occur during a takeover or going public.
- One must be careful when going through pro-forma earnings because it does not use the GAAP methodology for net income.
- There are situations where companies must focus on the pro-forma EPS instead of the official GAAP EPS. T
- The pro-forma EPS calculation for a merger or acquisition combines the incremental adjustments created through synergy and the net income of the acquirer and target. This numerator is then divided by the total acquirer shares and new shares added.
- By comparing the pro forma EPS to the original EPS of the acquirer, one can conclude whether the acquisition caused an accretion or dilution in the company’s earnings.
- The usefulness of pro forma EPS can be extended to earning forecasts, comparisons between companies in different industries, earnings announcements, and modeling a stock’s intrinsic value.
Understanding Pro-forma Earnings per Share (EPS)
Pro-forma Earnings per Share (EPS) is a projected earnings figure, adjusted for extraordinary items or changes, offering an estimate of a company's expected future earnings per share.
Since it does not reflect the official net income figure, it is possible for companies to hide additional costs to make their EPS prospects look superior to competitors artificially. This is an unethical practice as it hides a few relevant expenses from investors.
Similarly, there are instances where unsold inventory is left out. This is deceiving as the cost of buying inventory must be considered. If a major surplus has emerged, it is due to bad management as they were unable to sell enough inventory on time.
Nevertheless, if the necessary due diligence is done while reading pro-forma earnings, then it is a powerful tool that identifies the core value drivers of a company.
The outlook this type of EPS gives is required in certain industries with frequent depreciation costs. For instance, net operating profits in the telecommunications sector are hard to find when using the GAAP method. This makes the industry a prime example of this reporting.
Pro-forma Earnings per Share Considerations
Pro-forma EPS is a valuable tool for standardizing the earning potential of a company under different scenarios. For example, when analyzing certain corporate actions, earnings may get impacted temporarily, which does not reflect the company's future profitability.
Hence, to contextualize a company's structural changes, one must strip away earnings from such events. The most accurate way to do this is creating a pro-forma EPS figure which neutralizes the impact of one-time costs and changes to overall profits.
There are various situations where using this type of EPS is more beneficial than simply looking at the GAAP EPS:
1. Internal Performance
It is commonplace for investment banks to use pro-forma numbers to assess the prospects of value creation through operations. This provides a more accurate valuation figure which can be quoted for potential takeovers.
2. Change in the capital structure after the IPO
If there is a conversion of outstanding securities from preferred stock to common stock, it will result in a reduced EPS. To counteract this, a pro-forma EPS can be presented to show profitability levels before conversion.
Additionally, changes in capital structure will invariably change net income, impacting earnings.
Note
Pro-forma earnings are a useful measure for companies undergoing any kind of structural change
3. Debt Offerings
A company might raise debt to pay off existing debts. This would change its interest expense, in turn impacting the EPS as well. Hence, a pro-forma EPS is useful in providing an unaffected view of operations.
4. M&A impact on earnings
An acquiring company can determine whether buying or merging with the target positively or negatively affects its earnings per share.
Substantial one-time charges are incurred when a company goes through restructuring or a merger. Therefore, to better represent the combined EPS of the acquirer and target, it makes sense to use the pro-forma method as it accounts for incremental cost changes.
Note
Specifying which corporate actions or one-time costs impact earnings is important. If there is any ambiguity on whether a certain activity influences a change in EPS figures, then it should be left out of the calculation.
To quantify whether there is an accretive or dilutive impact on earnings for the acquirer post-M&A, the company’s new pro-forma EPS must be calculated. This can be examined in conjunction with the GAAP EPS to measure if the value has been created or destroyed.
Overall, this type of EPS takes away inessential costs that do not impact a company’s profitability. This figure is usually used by companies attempting to raise capital. After isolating the core value creation areas, it is easier for investors to see where profits are being made.
That said, the most important utilization of it is when a company goes through a merger or acquisition. This causes wholesale changes to earnings since a consolidated financial statement of the acquirer and target is prepared.
Example of Pro-forma Earnings per Share Calculation
It is important to understand that the formula for this EPS returns the estimated earnings per share of the combined entity post-merger or acquisition. This can then be compared to the prior GAAP EPS of the target to see the percentage difference in earnings after the changes associated with the takeover are accounted for.
The formula for pro-forma earnings per share can be represented by the equation below:
Incremental adjustments refer to additional value items created after a firm merges with or acquires the target. These include but are not limited to the following:
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Tax benefits, which occur when two companies are synergized (gain in assets).
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Interest expenses that emerge after a merger is debt-financed.
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Conversion of the target company’s preferred stock to common stock for the combined entity.
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Saved expenses from the liquidation of the target’s debt.
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The lost opportunity cost for the acquirer if the cash balance is used for takeover instead of other business functions.
To illustrate an example of the it at work, let's assume Company A is in the manufacturing business and is looking to acquire Company B, a smaller transportation company, to offset costs associated with shipping and distribution.
Now that manufacturing company A can use target company B’s transportation assets towards their operations, it would result in after-tax savings for the acquirer.
For example, to represent this incremental adjustment, let us say that using Company B’s transportation assets helps acquirer Company A save $1,000 in costs.
If Company A has total earnings of $8,000 with 4,000 shares issued, then one can calculate the initial EPS before acquisition. The earnings per share for Company A before the acquisition is simply 8,000 (total earnings) / 4,000 (number of shares) = 2.
This means Company A is earning $2 per share before the acquisition. Additionally, it is found that Company B has earnings of $3,000, and 1,000 new shares were issued to them by acquirer Company A to complete the acquisition.
Note
The number of shares outstanding for Company B is not required since they are being acquired. The acquirer will issue new shares to compensate for the target.
After the above information is available, one can calculate the new pro-forma EPS post-takeover. This can be represented by the following table below:
| Pro-forma EPS Acquirer Company A & Target Company B | ||||
|---|---|---|---|---|
| Inputs | Acquirer Company A | Target Company B | Incremental Adjustments | Pro-forma Inputs |
| Total Earnings | $ 8,000.00 | $ 3,000.00 | $ 1,000.00 | $ 12,000.00 |
| Shares Outstanding | 4000.00 | N/A | 1000 | 5000 |
| Company A GAAP EPS before Acquisition | $ 2.00 | = Total Earnings A / Shares Outstanding A | |
| Company A Pro-forma EPS after Acquisition of Target Company B | $ 2.40 | = Total Earnings / Shares Outstanding | |
| Percentage Impact of M&A on Company A's EPS | 20% | = (Pro-forma EPS - GAAP EPS) / GAAP EPS | |
The first thing to notice is that the after-tax savings of $1,000 for Company A under incremental adjustments. So, although it is a positive value, ordinarily, they would have lost $1,000 without the acquisition of the target Company B.
Similarly, new shares issued by Company A can technically be termed as an incremental adjustment, but it goes in the denominator of the pro forma EPS formula.
By adding up the after-tax savings post-acquisition for Company A and the total earnings for companies A & B, the EPS numerator can be calculated.
The denominator is simply shares outstanding for Company A plus new shares issued by the acquirer.
After contextualizing the inputs, it is fairly easy to calculate the pro-forma EPS for Company A after acquiring target Company B:
Pro-forma EPS Company A = (8000 + 3000 + 1000) / (4000 + 1000)
The new EPS is seen to be $2.40 since it is already known that Company A’s GAAP EPS is $2.00. Therefore, a comparison can be made to check whether the takeover created accretion or dilution for the company.
Acquiring target company B positively impacted the pro-forma EPS of Company A as it witnessed a 20% increase, taking it from $2.00 to $2.40 per share. This implies that the takeover was a good move by Company A’s management because the earning potential was boosted.
Pro-forma Earnings per Share (EPS) Usage
The importance of this earnings is rooted in its ability to identify core drivers of a company’s performance. This is imperative in conducting accurate analyses on future profit growth leading to more informed decision-making by shareholders.
Pro-forma EPS is a valuable tool for assessing a company's true financial health. Its calculation allows for greater insight into growth prospects and provides companies with a roadmap for future financial planning.
This makes it particularly useful in various areas of finance:
1. Earning Forecasts
One can compute future EPS numbers using assumptions and adjustments from the pro-forma framework, allowing investors to make more informed decisions on the earning potential of a stock.
2. Comparing Companies
Different industries might follow varied accounting practices, making it hard to draw conclusions from comparing their GAAP EPS.
However, isolating the main profitability factors through the pro-forma EPS allows for a more accurate representation of earnings across sectors.
Note
This makes it easier to discern whether a company is showing profit growth or its earnings are overstated based on its industry.
3. Earnings Announcements
Companies often present their pro-forma EPS alongside the official GAAP EPS to help provide investors with a clearer picture of performance.
This helps accurately forecast the future earnings of a company, in turn allowing analysts to create a more precise buy or selling rating for the stock.
While the potential negatives associated with pro-forma EPS figures were highlighted earlier in the article, one can conclude that when calculated accurately and with due diligence, it provides greater insight into company performance and earning potential.
Conclusion
To conclude, this type of EPS is a crucial financial metric used to assess a company's ongoing profitability by adjusting for one-time or non-recurring items. This normalization provides a clearer view of the core operating performance.
It is valuable for comparisons, strategic decisions, investor communication, forecasting, and valuation. Moreover, it can be applied in many ways, including its prominence in M&A deals and accounting for adjustments created through a change in capital structure.
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