Overview – Promising a Positive Future Through Pro Forma Earnings
Many of us are proud to showcase our achievements, especially when we’ve consistently been performing at a high level for such a long time. However, unexpected circumstances or unwelcome surprises sometimes pop up, which may cause our performance to temporarily decline, leading to the achievements we used to earn no longer ending up in our hands.
What do we do when this happens to us, especially when others ask us about the sudden drop in our performance? One way would be to look at these past shortcomings and explain that, had these unexpected circumstances/surprises not taken place, then we’d still be the high-achieving person that we always were. We could also explain that assuming certain conditions are met, we could expect to achieve even greater things in the future.
Many companies take a similar approach when their past financial performance isn’t up to their usual standard, whereby they make certain adjustments to paint a more ideal picture of what “normal” earnings should look like based on certain assumptions. On the other hand, some companies make certain assumptions in order to generate predicted future earnings.
These assumptions and the adjusted/predicted earnings produced because of them are known as pro forma earnings. In the context of investing, this modified form of earnings may prove to be helpful at best, or downright misleading at worst.
What Are Pro Forma Earnings Anyways?
When talking about pro forma earnings, it’s important to understand what context it’s being used in. Generally speaking, it’s used in one of two contexts.
First, we know that the financial statements that companies must report, at minimum, are the balance sheet, income statement, and statement of cash flows. However, there are times when a company may choose to adjust their income statement numbers – the earnings data produced as a result of these adjustments are known as pro forma earnings. These modified earnings figures can either be presented side-by-side with the original, reported data, or can be presented in another statement entirely, which is usually titled the pro forma earnings/income statement.
Pro forma earnings can also be used when making projections, such as when creating a business plan. Instead of adjusting pre-existing earnings data based on certain assumptions, in this scenario, we instead start with a certain set of assumptions and based on these create projected earnings figures.
Pro forma earnings also go by the moniker of non-GAAP earnings. This is because when creating pro forma earnings, there aren’t really any established accounting methodologies to abide by (which again highlights the importance of investors needing to know some basic accounting concepts). After all, the assumptions that are made to create pro forma earnings can vary wildly across different industries and companies, so it shouldn’t really come as a major surprise that pro forma earnings are classified as non-GAAP.
It’s also important to note that pro forma earnings aren’t something that needs to be reported on a regular basis. It’s something that’s only reported when a company decides to make adjustments to their earnings figures, which ideally isn’t something that should happen on a regular basis.
When it comes to investing, investors will most likely deal with pro forma earnings in the context of adjustments being made to the income statement, so this will be our focus for the remainder of this article. So how exactly can pro forma earnings help investors with their work, or on the flip side, how can they potentially be harmful?
How Pro Forma Earnings Can Be Helpful to Investors
Imagine you’re performing your annual portfolio review, and one of the companies you have in your portfolio consistently posts annual revenues in the range of $500 million – $750 million.
However, you notice that in their most recent fiscal year this revenue trend was broken: they reported annual revenue of $4 billion. Upon further inspection, you learn that because of restructurings that took place, $1.5 billion was due to the proceeds of the sale of certain assets, another $1.5 billion was due to the sale of certain business divisions, and yet another $300 million was due to other miscellaneous, one-time items.
The remaining $700 million is attributed to normal business operations, but even then this earnings figure was still affected in one way or another by all of the restructurings that took place.
With so many one-time business transactions happening all at once, it’s only natural to raise the question of “what would earnings look like had these extraordinary events not taken place?”.
In this scenario, it would make sense for the company to adjust their earnings based on the assumption that these one-time transactions didn’t take place, and instead demonstrate what earnings could’ve potentially looked like had the previous fiscal year been “normal”.
By producing these modified earnings, investors can use more accurate data when performing their analysis, thereby reducing the possibility of creating any outliers when performing certain analytical tasks such as ratio and discounted cash flow analysis, ultimately resulting in a better idea of a company’s financial health and investment merit.
Of course, pro forma earnings figures aren’t perfect. Some assumptions may prove to be overly strict, while others may seem a bit too generous (more on these later), resulting in data that may not be as accurate as possible. However, assuming the adjusted earnings figures were produced in good faith, then investors can rest a bit easier knowing that their analysis will still be reasonably correct and accurate.
How Pro Forma Earnings Can Be Harmful to Investors
Although many companies use pro forma earnings as a way to provide a better financial picture to investors, some companies may choose to adjust their earnings with some nefarious intentions in mind.
Given its non-GAAP nature and the countless assumptions/adjustments that can be made, it’s very easy to use pro forma earnings as a way to hide bad financial performance at best or to commit outright fraud in a worst-case scenario.
For example, imagine a company that has recently secured a major project from a high-profile client. Over the next five years, the client agrees to pay a total of $5 billion, with the company slated to receive $1 billion a year. However, instead of reporting $1 billion every year, through a bit of creative accounting and some questionable adjustments, the company is instead able to report $2.5 billion in annual revenue over the next two years – a very cheeky way to make their financial performance seem better than it actually is.
Or take for example a company that has recently posted some very disappointing earnings figures in the past few years. As a way to assure investors that things aren’t as bad as they seem, they publish a pro forma earnings statement in their most recent annual report based on the major assumption that had they magically not encountered the difficulties they faced and the business environment was more forgiving, then their financial performance would’ve been much better.
There are countless other examples that we could go over, but the point still remains: it’s very easy to fudge the numbers and make them look better than they really are simply by making some very generous assumptions and performing some very clever adjustments.
Investors who use pro forma earnings that were created with nefarious intentions in mind run the risk of grossly misjudging a company’s performance or a prospect’s investment merit. This could lead to a very inaccurate investment analysis at best or a horrible investment decision at worst.
It’s very easy for companies to say that they have investors’ best interests at heart, but talk is cheap, and it’s entirely possible for some companies to show their true colours when their financial performance begins to slip and the pressure to turn things around starts to build.
If that’s the case, does that mean pro forma earnings are something that should be avoided? Not at all. As long as an investor takes certain precautions, then they can use these modified earnings figures without much worry.
Some Precautions Investors Can Take When Working With Adjusted Earnings
We now know that pro forma earnings can be used as a way to present investors with a more accurate picture of financial performance by making certain assumptions and adjustments, but because of their non-GAAP nature, they can also be used as a way to mislead investors.
If an investor decides to use pro forma earnings in their analysis, then what are some things they can do to minimize the possibility of being misled?
The first, and arguably most important, step is to understand what sort of assumptions/adjustments are being made. A company that truly has the best interests of its investors and stakeholders at heart should have no problem disclosing what those assumptions/adjustments are and explaining the rationale behind each one with a sufficient amount of detail.
If you’re serious about using pro forma earnings in your work, then it would be in your best interest to thoroughly understand what those assumptions/adjustments are and to judge whether they sound reasonable or not. Deciding whether these assumptions/adjustments sound “reasonable” will ultimately come down to your investment experience and intuition.
Remember that investing is all about making comparisons. Data analyzed on its own is meaningless: insight can only be gained when appropriate comparisons are made. $10 billion in annual revenue in the previous fiscal period might not sound too bad for a certain company, that is until you learn that all of its competitors made at least $100 billion.
Therefore, when working with pro forma earnings figures it would be wise to compare them with the reported earnings figures as well. By doing this, you see exactly how drastic the differences are between the reported and adjusted earnings data, and as a result, you can better judge if the assumptions made to create these adjusted earnings figures truly are reasonable or not.
No sensible person would look at adjusted data without having the original data in hand, so when it comes to looking at pro forma earnings the same logic applies.
These are just some very simple measures investors can take to protect themselves from the risks of using non-GAAP earnings figures, but even doing simple things like these can make all the difference.
Wrapping Up
Sometimes, extraordinary circumstances and unwelcome surprises may cause a sudden hit to a company’s financial performance. In order to assure investors that this slump in performance is indeed attributable to forces beyond their control, companies may choose to adjust their earnings to create a clearer picture of what “normal” financial performance may have looked like.
Assuming they’ve been created in good faith, pro forma earnings have the potential to help investors with their analysis and decision-making, but if they were instead created with nefarious intentions in mind they could severely harm investors.
Because pro forma earnings are a double-edged sword, there are some precautions that investors can take. Taking the time to understand what sort of assumptions were made and comparing the adjusted earnings data with the unadjusted figures are some simple yet effective ways to reduce the risks of using misleading pro forma data.
