Question for the analysts here

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The question I’d like to see discussed, if you would be so gracious, is: "Is Depreciation a reasonable proxy for “wear and tear…or general upkeep cost… of plant and equipment?”

Perhaps framing the issue that raises the question is that I view CAPEX as the investment into future productive capacity, whereas it seems to me that many analysts view CAPEX as the maintenance cost, which seems odd when most plant and equipment is depreciated (i.e a piece of equipment that has an expected economic life of, say, 10 years is depreciated over that span).

Since many here do “deep dives” I figure that I ought to be able to get interesting viewpoints from those who are gracious enough with their time to share them.

I guess a corollary question would be: "Does one view intangible assets (i.e. R&D, patents, etc.) as Depreciating assets or as CAPEX (since some of these costs can be quite high)? I’m not asking about acquired intangibles, just those incurred by the existing enterprise.

Appreciate any feedback.

Poz

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I would be surprised at an analyst treating CAPEX like maintenance. Maintenance is its own valid expense item. Capital equipment gets depreciated because, well, it depreciates, i.e., has a reasonable useful life. For some things that may be 5 years; for others 20, but these are matters of standards, not caprice. Depreciation has nothing to do with upkeep, but is a simple recognition that one spends a lot of money in the beginning and that cost has a limited expected life before what one bought no longer has any use.

The only real “game” here is the choice of depreciation method. Front loaded methods like double declining balance expense the majority of cost in the first years of ownership. This may actually be a good fit for something like an automobile, but has the potential disadvantage that one gets less deduction in later years, unless one spends new money.

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Hi PosFCF

It is true depreciation is not a cash expense but you can see as the asset ages you will need to reinvest some money for maintenance. So you can classify this as maintenance capex required to keep the asset productive. Ultimately this expense is a drain on you FCF (free cash…is that what you have in your id). The way I think about is after a few years you don’t realize the full benefit of depreciation since a fraction has to reinvested. e.g Disney spends $ after 8 years on repainting.

R&D expense should be amortized since the benefits of R&D are realized over multiple years. You can base the amortization on # of years it takes to commercialize IP. e.g. for electronics manufacturer it would 2-3 years whereas for a pharma would be 15-years. Once you decide to amortize you need to correct the EBIT. Add back the R&D expense and subtract amortized portion.

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Does anyone have a book they’d recommend on this and other calculations?

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Does anyone have a book they’d recommend on this and other calculations?

Cash Flow and Security Analysis – Hackel and Livnat

https://openlibrary.org/books/OL802114M/Cash_flow_and_securi…

Free Cash Flow – George Christy

https://www.wiley.com/en-us/Free+Cash+Flow%3A+Seeing+Through…

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Poz,

I think you can simplify it by thinking of your personal car. If you don’t change the oil every 5,000 miles and the tires when then get bald, it won’t last very long. That’s maintenance.

After, say 90K miles, you find yourself spending more significant bucks to keep the jalopy running (timing belt, water pump, maybe an exhaust pipe).

After, say 300K, the think is costing more than it’s worth and it’s time to buy a new victim. That’s its expected life. Simplistically, dividing the original cost by the number of years it takes to get to this state gives you the annual depreciation (which may differ from the schedule allowed/mandated by the tax guy).

When we used to evaluate the relative cost of computer printers, we took the manufacturer’s projected life expectancy (which was the number of sheets of paper it was rated to handle per month, multiplying by 12 and then by five years) and figured out the cost of supplies for that number of pages, plus the periodic larger costs (drums, for example), plus any maintenance contracts or technician costs we felt would be reasonable and added them to the cost of the printer. We called this the “total cost of ownership” of the gadget.

We then divided by the total number of sheets and multiplied by the number of sheets we expected to print per month.

Depending on the actual usage, the printer might last far longer or shorter than it’s 5 year life expectancy (thereby not matching a 5 year depreciation schedule based on the manufacturer’s projection).

Incidentally, it was not unusual, using the above method, to find a $1,000 printer fast laser printer being far less expensive per month than a $80 dollar inkjet printer - a fact which was difficult to promote to a school with a limited capital budget, but a more flexible operating budget.

Jeff

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Hi Poz.

I certainly do “deep dives”, but calling me an “analyst” might be a stretch, except to the extent that I have good, general-purpose, analytic capabilities. Despite “TMF” in front of my name, I am not a TMF employee, merely a contractor.

Sadly, I think the answer to your question is, “It depends.” I think the industry you’re examining is a major determinant of how much “it depends”.

For most industries, I will certainly compare CapEx and Depreciation. For a growing company, I’d expect CapEx to be higher because it is more of a “leading indicator”, if you will, where depreciation is more of a “current indicator” (at its best). One industry that quickly comes to mind where “depreciation ISN’T a reasonable proxy…” is Real Estate Investment Trusts, generally. Typically, in that space, assets are depreciated over time frames that severely underestimate their useful lives. That’s why the PE ratios of so many REITs are sky-high, and those familiar with the asset sub-class generally pay attention to “funds from operations” instead of earnings. But let’s set aside REITs for now.

For most industries, I expect CapEx to be lumpier than depreciation, but I generally want to see it at least keeping up with depreciation, based on long-term averages. If it isn’t, I need to understand why. I suppose there are some acceptable answers, especially if the business’ model is shifting. But mostly it should be more than “keeping up” – it should be leading.

I’ve found that when manufacturers are investing heavily in CapEx, that often depresses their current price. My best explanation for that is that the costs are certain, and the benefits of the spending are merely “hoped for”. But if you feel confident in the company and feel as if the CapEx is being spent wisely, it is often a good opportunity to exploit price weaknesses.

One of the ways that I try to make my analysis more conservative is that I typically assign little or no value to goodwill or intangible assets (acquired or otherwise). I’ve studied some acquisitive companies – some where tangible equity was negative – and bought them anyway, so I’m not a slave to the idea that intangible assets are worthless. I just feel as if it is useful starting point. Things only get better from there!

Thanks and best wishes,
TMFDatabaseBob
See my holdings here: http://my.fool.com/profile/TMFDatabasebob/info.aspx
Peace on Earth

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tamhas

I would be surprised at an analyst treating CAPEX like maintenance.

Thank you for responding to my question.

As I understand it, the simplified version (I understand that accounts payable and receivables can be jiggered with), but in a back-of-the-napkin first run simplification of determining Free Cash Flow (FCF) is:

[CFO is Cash From Operations in this formula]

FCF = CFO + Depreciation - CAPEX

If CAPEX is subtracted from a company’s financial results, then isn’t that akin to putting it into the “maintenance bucket?”

That was the thinking behind the portion of my OP that you addressed…I apologize for not making that clearer in my OP.

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risksafety

Again, thanks to everyone for taking the time to engage in this discussion, it is my attempt to see where my thinking on the quick-n-dirty FCF determination I use has major flaws in its premises and (as is likely) it does, then to have your quality input to reflect upon to figure out what changes I might need to make.

It is true depreciation is not a cash expense but you can see as the asset ages you will need to reinvest some money for maintenance.

Since it often difficult to determine how much a company spends on maintenance, many years ago I defaulted to considering Depreciation as a proxy for that cost in looking at FCF. I have figured that it may be off to some degree from absolute accuracy, but the thinking was that, if used across industries, it would treat the FCF determination the same.

Poz

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earslookin

Thanks for the book suggestions. I realize that we have butted heads in other venues, and for that I apologize.

Much of my approach to FCF determination has been formed by thinking elucidated in the Hackel and Linat book (a tough read for me, BTW…it might be easier now than when I read it…but then again, I am learning through my efforts to refamiliarize myself with the higher levels of math that was so easy for me the first time…my mind is not as flexible as once it was…

One of the major ideas from that book that rang a bell for me and clarified much was the concept of thinking through whether an item was an “optional use of cash” (thus could be added to the positive side of FCF determination) and then determining which were not optional.

Do you suggest reading both (i.e. do they pretty much cover FCF pretty much the same way)?

Poz

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Jeff

Always appreciate your input. Like your cost-per-printed-page, there are some details of real costs versus accounting costs that often depend on the business management; some are very maintenance conscious to get the most value for their investment while, inexplicably, there are some who appear to be unconcerned.

But in a quick-n-easy first run at FCF determination, I have no way of knowing which style of management an unknown-to-me company might have…reading the financial statements and listening to the conference calls and evaluating performance versus guidance is necessary for me before committing much money to an enterprise. However that part of the study is very time consuming…which I don’t mind, but it makes going through the universe of publicly traded enterprises very difficult, and for the most part, wasted effort … for many more entities hit the discard pile than make the lets-look-further-into-this-one pile. I mean that even for the discarded pile there might be the occasional pointer to new tricks in which accounting makes lipstick for the pig…

Poz

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TMFDatabaseBob

For most industries, I will certainly compare CapEx and Depreciation.

Yeah, that is an interesting comparison, isn’t it?

…Real Estate Investment Trusts, generally. Typically, in that space, assets are depreciated over time frames that severely underestimate their useful lives.

In general, I have also found some companies that have completely depreciated assets which they still are profitably using…I try to factor that in my calculations of book value…

However that notion has also played a part in my calculation of FCF being a bit different than the formula that seems to be widely used…

Having been a residential mortgage originator for about a dozen years (ending quite some time ago), I do understand that properties can be well into their depreciation usage, but have a much younger effective age. For example, if a house were to start out with a 65 year lifespan from an accounting viewpoint, and it was 45 years later that a new owner wanted to buy it, the appraisal would depreciate the buildings at the effective age, not at the true age (although sometimes there wasn’t much difference) thus recapturing, in part, the care and maintenance of previous owners. It was often impossible to have lenders provide a mortgage loan for a term longer than the 65 years minus the effective age.

One concept in the real estate space that I occasionally wrestle with is the paradigm that land doesn’t depreciate but structures do. If one looks at the price of vacant land…that value can vary, sometimes considerably, over the cycle. Haven’t quite figured out how to factor that aspect in a quick-n-dirty manner.

One of the ways that I try to make my analysis more conservative is that I typically assign little or no value to goodwill or intangible assets (acquired or otherwise). I’ve studied some acquisitive companies – some where tangible equity was negative – and bought them anyway, so I’m not a slave to the idea that intangible assets are worthless. I just feel as if it is useful starting point. Things only get better from there!

I mostly use that thinking too. However the depreciation of those assets does show up in the Statement of cash flows…which is another factor in considering whether adding back depreciation should be the go-to treatment.

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PosFCF, I think one of the possible issues here is that some metrics like this are borrowing from both the P/L statement and the Balance Sheet. In the P/L, depreciation is an expense and reduces the bottom line whereas CAPEX spending does not show up on the P/L at all, except for the portion which is depreciated in any given year.

Thus, this FCF formula is taking the cash generated by operations, add back in the depreciation since that is not actually a current cash expenditure, and the subtracting CAPEX since that is real money going out the door, even though it doesn’t show up on the current P/L.

Maintenance is a current expense which has nothing to do with depreciation or CAPEX.

Make sense?

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tamhas

PosFCF, I think one of the possible issues here is that some metrics like this are borrowing from both the P/L statement and the Balance Sheet. In the P/L, depreciation is an expense and reduces the bottom line whereas CAPEX spending does not show up on the P/L at all, except for the portion which is depreciated in any given year.

Thus, this FCF formula is taking the cash generated by operations, add back in the depreciation since that is not actually a current cash expenditure, and the subtracting CAPEX since that is real money going out the door, even though it doesn’t show up on the current P/L.

Maintenance is a current expense which has nothing to do with depreciation or CAPEX.

Make sense?

Well, I understand the hypothesis but have a problem in believing that depreciation isn’t a real expense. The problem is that it is added back for FCF while no measure of maintenance takes its place…that, to me, is akin to believing there are only lump sum (CAPEX) charges for plant and equipment which always need some form of maintenance expense to ensure that at least the accounting life is achieved. It is kind of like Ormont’s example of the deferred maintenance on a vehicle all of a sudden resulting in blown engines, new tires, and eventually an annual cost of maintenance that makes buying another vehicle a real consideration.

The reason I determine FCF is because there has been so much gaming of the Income Statement and the Balance Sheet, in recent years with stock buy backs and shares issued and credited there instead of on the Income Statement.

I realize that using Depreciation as a proxy for maintenance expense might be harshly treating the FCF determination of a company…but I’d rather be too conservative than not conservative enough…and it is really the relationship between Depreciation and CAPEX that I try to capture.

A company that under-invests in the factors of future production will have an FCF showing more positive than, perhaps, is warranted by aging productive assets, while a company that engages in ensuring quality future productive capacity will have a higher CAPEX deduction reducing the FCF under the standard simplified FCF equation.

What I am after when I perform the FCF back-of-napkin approach is not precision but a relatively close approximation…close enough to immediately disqualify those companies that are out of range and immediately point me toward those who pass the criteria. That is all I’m after…the saving of time and energy so that it can be deployed toward investigation of apparently higher value enterpises…

Hope my approach has been stated clearly enough, but not sure I’ve done so…I guess I’m just concerned that the standard equation isn’t capturing a conservative enough picture…and trying to figure out why and what to do about it.

I appreciate the time and effort you are taking.

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Poz,

I think I understand what you are saying. (I really need to take an accounting course.) It seems like you attempting to ferret out and account for defered
maintenance as a company can game Free Cash Flow by taking depreciation and not performing deferred maintenance.

Tricky, real tricky.

How does one determine when a company has a made a prudent decision to not maintain legacy equipment or products and when a company is cutting corners to juice its numbers?

In telecom, we have copper cable hanging everywhere. As a craftsman who wants to see high quality service bad cables hanging in the air are an anathema. However, the CFO sees cables that are generating cash flow and that he can get special treatment for when they are blown over in a hurricane, and/or cables that will be replaced with buried fiber in the next CAPEX build.

If a person was to just step back and look the good sense of allowing the system to rot makes excellent sense.

On the other hand, buy letting the cable rot along with the power infrustructure and running the fiber deployment late, the CFO pads the free cssh flow by adding risk of a BP moment. (The moment that bringing that oil well in on budget ceased to be important)

How does one winnow out what is prudent and what is juicing the numbers?

Cheers
Qazulight (My car buying, boat buying airplane buying experience is: if its ugly on the outside, its uglier on the inside)

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Qazulight

How does one winnow out what is prudent and what is juicing the numbers?

That, ultimately, is the many zeros dollar question…and many here have done that with their deep dive analyses. Sometimes I’m able to do it as well.

What many do, is to have some kind of initial filtering process which peels off the fraction of companies so that their efforts result in a lower amount of wasted effort…sort of along the lines of your “if it is ugly on the outside, it’s uglier on the inside” heuristic.

I try to use FCF as that filter, lately I’ve been using cash on hand compared to total debt as an early indicator…that under the belief that some time, perhaps soon perhaps not, interest rates on debt will climb back into high single digits and those enterprises with low cash and high debt will more likely to be found swimming naked when the low rate tide goes out.

Poz

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PosFCF, depreciation is not a real current expense. Suppose you are in a business and you buy a big machine for $1M that has an expected 10 year useful life. If you account for that purchase on a cash basis, you have this whopping big expense in year 1 and none of that expense in years 2 through 10. If, however, you do a straight line depreciation, then you have $100K in expense each year, which is probably more reflective of the current state of the business.

But, if you are trying to look at cash flow, then that depreciation doesn’t reflect any actual cash going anywhere whereas the purchase of the machine does represent real cash flow. So, in year 1 the FCF = CFO - $100K + $1M subtracting out the first year’s depreciation and adding in the purchase. In year 2 the FCF = CFO - $100K because only the depreciation is happening. Of course, for a real business of any size, there is likely to be new purchases each year to smooth this out.

None of this has anything to do with maintenance. It is only a way of accounting for the purchase that separates the lumpy cash flow from the on-going average state of the business.

Note that this same separation exists in paying for the machine. When you buy the machine, you are going to add $1M to your assets and start expensing the depreciation. But, in one case you may have paid for the machine out of available cash and in another case bought it on time over say three years.

To be sure, there is likely to be maintenance costs for this machine, but that will be an entirely separate item in the operating expenses with no connection to the capital equipment accounting issue.

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How does one winnow out what is prudent and what is juicing the numbers?

I think this takes genuine understanding of the business and is not something that one can determine by simple massaging of the financial statements.

In your telecom case, for example, one might compare the expenses of two similar companies to get an idea of which was investing in the future and which might have a liability of lots of ancient infrastructure, but to really come to any conclusion one would have to dive into the businesses themselves, not just add, subtract, divide, and multiply figures on the financial statements.

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tamhas

But, if you are trying to look at cash flow, then that depreciation doesn’t reflect any actual cash going anywhere whereas the purchase of the machine does represent real cash flow. So, in year 1 the FCF = CFO - $100K + $1M subtracting out the first year’s depreciation and adding in the purchase.

But don’t you have the addition and subtraction functions reversed vis-a-vis the accepted formula?

Isn’t the equation: FCF = CFO + Depreciation - CAPEX therefore in your example the equation numbers would be FCF = CFO **+**100K - 1M?

BTW, the formulation you listed is much closer to what my conclusions would be: subtracting depreciation and adding CAPEX…because CAPEX is an optional use of cash while depreciation is a proxy for maintenance, wear, and tear, and obsolescence.

Poz

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But don’t you have the addition and subtraction functions reversed vis-a-vis the accepted formula?

Yes. Sorry.

because CAPEX is an optional use of cash while depreciation is a proxy for maintenance, wear, and tear, and obsolescence.

No. Maintenance is its own line item. Wear and tear is just a part of useful life. Depreciation is a “proxy” only for the original purchase, spreading it over time so as to not distort results by a one time act which has a useful life over many years.