Proforma earnings per share (EPS) is the calculation of EPS assuming a merger and acquisition (M&A) takes place and all financial metrics, as well as the number of shares outstanding, are updated to reflect the transaction. “Pro forma” in Latin means “for the sake of form.” In this case, it refers to calculating EPS “for the sake of form” in the event of the acquisition.
Basic EPS is calculated by dividing a firm’s net income by its weighted shares outstanding. The pro forma EPS, on the other hand, adds the target firm’s net income and any additional synergies or incremental adjustments to the numerator, while adding new shares issued due to the acquisition to the denominator.
Pro Forma EPS = (Acquirer’s Net Income + Target’s Net Income +/- “Incremental Adjustments”) / (Acquirer’s shares outstanding + New Shares Issued)
These are additional value items that are created when the two firms combine, which impact proforma earnings per share:
- Incremental after-tax interest expenses that come from new debt financing.
- After-tax synergies (gains in assets).
- After-tax depreciation and amortization expense (from write-ups).
- Lost opportunity cost of cash balances if used to finance the acquisition.
- “Saved” after-tax interest expense from the liquidation of target’s debt.
- “Saved” preferred stock dividend payment from liquidation or conversion of target’s preferred stock.
Q. XYZ Ltd. is considering merger with ABC Ltd. XYZ Ltd.’s shares are currently traded at Rs. 25. It has 2,00,000 shares outstanding and its profits after taxes (PAT) amount to Rs. Rs. 4,00,000. ABC Ltd. Has 1,00,000 shares outstanding. Its current market price is Rs. 12.50 and its PAT are Rs. 1,00,000. The merger will be effected by means of a stock swap (exchange). ABC Ltd. has agreed to a plan under which XYZ Ltd. will offer the current market value of ABC Ltd.’s shares:
(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both the companies?
(ii) If ABC Ltd.’s P/E ratio is 8, what is its current market price? What is the exchange ratio? What will XYZ Ltd.’s post-merger EPS be?
(iii) What must the exchange ratio be for XYZ Ltd.’s that pre and post-merger EPS to be the same?