Given investors’ focus on earnings as a key indicator of a company’s efficiency and financial potential, earnings numbers clearly have a significant impact on public market valuations. While earnings per share calculations seem straight forward, companies often report “pro forma” EPS numbers as well. Basing valuations on these pro forma numbers versus GAAP EPS numbers can translate into significant changes in valuations.
Pro forma earnings are non-GAAP numbers and may exclude items such as restructuring charges, asset impairment charges, losses on the sale of businesses and assets, goodwill amortization, and losses on equity method investments. While companies claim that pro forma numbers are net of “items they deem non-reoccurring, non-cash or otherwise unimportant,” and that pro forma numbers portray a more accurate picture of their value and potential.
The Predictive Value of Expenses Excluded from Pro Forma Earnings study analyses the informational value of pro forma earnings numbers. The study concluded that charges excluded from pro forma earnings were in fact meaningful and important.
In the 4th quarter of 1997, pro forma earnings were 17-21% greater than GAAP numbers. This signals a cause for concern that companies may be providing financials that are misleading by removing charges which negatively impact the company’s performance, even if though GAAP require those charges to be included in earnings. Even more disturbing, is that companies will often highlight these better pro forma earnings numbers and bury GAAP numbers further back in press releases.
However, there is some value in these pro forma numbers. The SEC wrote in a 2001 release that “companies may quite appropriately wish to focus investors’ attention on critical issues.”
While pro forma numbers maybe misleading, investors are not free from a responsibility to analyze how pro forma numbers are being calculated and determining their validity. GAAP earnings numbers are also provided and investors must make an educated determination on how to evaluate a company.
Yes, Bevin, you’re right that pro forma numbers are higher the vast majority of the time. However, pro forma numbers are supposed to be reflective of the ongoing operations of the Company, so there are legitimate reasons to exclude certain charges.
I agree that a solution to this is companies not “headlining” pro forma numbers, which could be misleading. The thesis that investors must be responsible to analyzing what’s included and/or excluded from pro forma numbers still holds true though.
I think that one point that was left out of this post is the fact that while pro forma numbers can exclude both losses and gains that are left out of GAAP numbers, it is far more often for pro forma numbers to only exclude losses. For instance, one-time sales of assets could be excluded from pro forma numbers, since they can be assumed to be unimportant in the sense that they will not recur in the future. However, analysis of pro forma earnings has shown that 88% of the time the pro forma number is higher than the GAAP number and that companies that have a GAAP loss are more likely to state pro forma numbers than companies with a GAAP profit.
A potential solution to this problem would be for a company to either show both numbers side by side so that one is not put front and center more than the other – or for the FASB to issue some guidance in terms of how pro forma numbers can be calculated. Although I understand that the calculation of what goes into pro forma numbers differs between companies and industries, investors would benefit from having some assurance that certain gains or losses could not be excluded from pro forma numbers and that pro forma numbers are being calculated consistently from one financial period to the next.