What are pro forma earnings?

Great question, but it is not easily answered, because pro forma earnings figures are inherently different for different companies. There are no universal guidelines that companies must follow when reporting pro forma earnings, which is why the distinction between pro forma and earnings reported using Generally Accepted Accounting Principles (GAAP) is very, very important.

GAAP enforces strict guidelines that companies must follow when reporting earnings, but pro forma figures are better thought of as "hypothetical", computed according to the estimated relevance of certain events/conditions experienced by the company. Basically, companies use their own discretion in calculating pro forma earnings, including or excluding items depending on what they feel accurately represents the company's true performance.

Items often left out of pro forma figures include the following: depreciation, goodwill, amortization, restructuring and merger costs, interest and taxes, stock-based employee pay, losses at affiliates and one-time expenses. The theory behind excluding non-cash items such as amortization is that these are not true expenses and therefore do not represent the company's actual earnings potential. Amortization, for example, is not an item that is paid for as a part of cash flow. But under GAAP, amortization is considered an expense because it represents the loss of value of an asset.

One-time cash expenses are often excluded from pro forma because they are not a regular part of operations and are therefore considered an irrelevant factor in the performance of a company's core activities. Under GAAP, however, a one-time expense is included in earnings calculations because, even though it is not a part of operations, a one-time expense is still a sum of money that exited the company and therefore decreased income.

The smart investor has to be very cognizant of a company's intentions when calculating or releasing pro forma earnings. Companies can use pro forma figures as a means of lessening the blow if actual GAAP earnings are below estimates. For this reason, investors must examine not only the pro forma earnings, but also the GAAP earnings. And never mistake pro forma for GAAP! Although a company reporting pro forma earnings is not doing anything fraudulent or dishonest (because it does report exactly what is and what is not included), it is very important for investors to know and evaluate what went into the company's pro forma calculation, as well as to compare the pro forma figure to the GAAP figure. Often, companies can have a positive pro forma earnings figure while having a negative GAAP earnings figure. When analyzing any company, it's up to the investor to decide which figure is a better indication of performance.

A final cautionary note for when you are analyzing pro forma figures: because companies' definitions of pro forma vary, you must be very careful when comparing pro forma figures between different companies. If you are not aware of how the companies define their pro forma figures, you may be inadvertently comparing apples to oranges.

(For more information on earnings and pro forma calculations, check out these articles: Types of EPS and The Tricks and Treats of Pro Forma Earnings.)

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