The cons of pro forma earnings

Paul DiGiacomo, Senior Analyst | January 7, 2014

  • Analysts assimilate data from many sources to evaluate a company’s underlying earnings potential.
  • Over the last 20 years, company managements have adjusted generally accepted accounting principles (GAAP) results to aid analysis.
  • As pro forma earnings proliferate, analysts must carefully evaluate treatment of reported results.

As the fourth quarter comes to a close, analysts are adjusting their earnings estimates for the final months of the year, and refining their longer-term forecasts. While precisely predicting quarterly results is difficult, appreciation of industry trends, analysis of financial statements, and assessment of management help to estimate a company’s underlying earnings potential. Often, we will include the effect of future corporate actions, such as an acquisition, or exclude one-time items, such as the costs associated with integrating that acquisition.

Over the last 20 years, the use of “pro forma” earnings, where managements arbitrarily omit certain items from results, has proliferated, ostensibly to help analysts. While the exclusion of some non-recurring charges is necessary, omission of other items can lead to inflated earnings and overvalued stocks. In fact, a Wolfe Research study of the Russell 3000 index found that 10-15% of constituents with a market capitalization above $1 billion presented results on a non-GAAP basis. Further, the three most commonly excluded pro forma items were stock-based compensation expense, restructuring charges, and intangible asset amortization.*

Chart: Commonly excluded pro forma items

Source: Wolfe Research

In many instances, the decision-making is straightforward. But, analysts often wrestle with the proper treatment of unusual situations. For example:

  • During its recent initial public offering, Aramark disclosed that the company would spend $35 million to repaint its trucks in a re-branding initiative. Is this a recurring marketing expense or just one-time?
  • As a serial acquirer, Stericycle excludes acquisition and integration expenses from its results every quarter. Are these one-time charges or an ongoing cost of the company’s growth strategy?
  • Over the last three years, IHS has adjusted its earnings to omit stock-based compensation expense, which has averaged 8% of revenue and 9% of operating costs. Is this appropriate?

Experience helps, and drawing on the expertise of other analysts and portfolio managers is critical when confronted with these issues. Importantly, while the market tends to properly discount management smokescreens most of the time, uncovering the true economics of a business can yield meaningful opportunities to add value to portfolios.

In the near-term, the global economy will grow at a modest pace, and many companies will have difficulty posting superior revenue and earnings growth. As a result, managements will cast earnings in the most positive light, leading to greater use of pro forma adjustments, and even outright manipulation. In response, analysts must carefully determine the proper treatment of results, in order to correctly value a security and ultimately inform the buy/sell decision.


*Senyek, Calingasan, and Chang, “Pro Forma Earnings”, May 9, 2013.