March 24 (Reuters) - Shares of Puig surged around 16% on Tuesday, on track for their best trading day on record, after the Spanish beauty group and Estee Lauder ( EL ) said on Monday they were in talks over a potential merger.

The deal would create a $40 billion luxury beauty group and bring some of the world's biggest beauty and fragrance brands such as Tom Ford, Carolina Herrera, Rabanne and Clinique under the same roof.

The combination would give the companies a strategic position in the global fragrance industry, which is facing a slowdown in demand after several years of strong post-pandemic growth, as Puig brings in more than 70% of its revenues from fragrances.

"While valuation of beauty assets is under pressure in the broader space, we would think a deal would have to be at a substantial premium to the current share price," J.P. Morgan said in a note to investors.

Part of the rationale behind merging Estee Lauder ( EL ) and Puig is that a combined company would better compete with L'Oreal, a source familiar with the deal told Reuters on Monday.

The discussions between Estee and Puig come just months after Gucci-owner Kering agreed to sell its beauty business to L'Oreal for $4.7 billion.

Estee Lauder's ( EL ) New York-listed shares closed 7.7% lower on Monday.