Depreciation
Last weekend, I was concerned with unusually soft sound coming out from my centre speaker among my more than 15 years old 5.1 home theater system. I tried to swap this speaker for another speaker for centre speaker. The problem was resolved as I am hearing clear and sharp sounds each time there is a dialogue in a movie.
That brought me to start thinking about depreciation and the lifespan of products. The first quote in my mind is:
“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?"
Warren Buffett, Shareholder Letter 2002
EBITDA is particularly relevant metric if you want to compare company A with company B, excluding their different depreciation and amortisation policies, and interest and tax schedules. No doubt, many investment bankers use it to illustrate how attractive a company is.
If we are going to use it for valuation (as if depreciation and amortisation plays no role), we will have a problem. Fixed assets are there to help us to do things in efficient manner (in terms of productivity and product/service quality). When fixed assets appear to be less efficient or is going to 'death', we will have to replace them. with new and better one in few years/decade later. Clearly, we have to take account of depreciation - the capital investment into fixed assets are capitalised and then its cost is spread over few years by accounting standard. I think it is important to take account of depreciation so as to see how company has grown quantitatively in your point of view.
What about the scenario when CEO made such decision to replace fixed assets that are in good working condition with better ones for productivity or cost cutting measures? One example is when OCBC Bank has began installing better machines (with automated functions which bank tellers can do) to replace standardised ATM. In these kind of situations, the depreciation schedule may be cut and incur full disposal cost. The trend of standardised free cash flow can be good indicator for this, illustrating how often the company made such investment yearly.
Although both situations show different business behaviours, inclusion of depreciation and amortisation into valuation tell us how much the companies need to incur the replacement cost. It tells us which industry require heavy replacement cost. This brings me to next two quotes:
“Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us.”
Warren Buffett, Shareholder Letter 2007
"Loomis: In your 1987 Letter to Shareholders you mentioned that Berkshire liked to invest in companies requiring only small amounts of capital. Now you are investing in companies with large capital needs. Why this change?
Buffett: Companies with little need for capital are harder to find. Berkshire Hathaway Energy and BNSF Railroad require lots of capital. We earn decent, but not extraordinary returns on capital.
Munger: When circumstances changed, we changed."
Berkshire Hathaway Annual Meeting 2016
Most consumers and business-driven software manufacturers are switching from direct purchase (before 2010s) to monthly subscription (in 2010s and in the future). It appears to me that depreciation has replaced by subscription costs. With internet of things and cloud computing, many businesses and consumers don't have to buy entirely new software for the sake of new features. The new features are automatically added from time to time - it is very noticeable if you have used Intuit's Quickbook Online. Sadly, I have not made an investment in Intuit stock - I am just too slow to recognise that it has led to huge revenue incremental over few years.
To sum these above up, it pays to be careful and prudent to reserve cash for the replacement cost in order to maintain the growth of the company. Meanwhile, I will have to shop for new speaker when I have time to do so.
That brought me to start thinking about depreciation and the lifespan of products. The first quote in my mind is:
“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?"
Warren Buffett, Shareholder Letter 2002
EBITDA is particularly relevant metric if you want to compare company A with company B, excluding their different depreciation and amortisation policies, and interest and tax schedules. No doubt, many investment bankers use it to illustrate how attractive a company is.
If we are going to use it for valuation (as if depreciation and amortisation plays no role), we will have a problem. Fixed assets are there to help us to do things in efficient manner (in terms of productivity and product/service quality). When fixed assets appear to be less efficient or is going to 'death', we will have to replace them. with new and better one in few years/decade later. Clearly, we have to take account of depreciation - the capital investment into fixed assets are capitalised and then its cost is spread over few years by accounting standard. I think it is important to take account of depreciation so as to see how company has grown quantitatively in your point of view.
What about the scenario when CEO made such decision to replace fixed assets that are in good working condition with better ones for productivity or cost cutting measures? One example is when OCBC Bank has began installing better machines (with automated functions which bank tellers can do) to replace standardised ATM. In these kind of situations, the depreciation schedule may be cut and incur full disposal cost. The trend of standardised free cash flow can be good indicator for this, illustrating how often the company made such investment yearly.
Although both situations show different business behaviours, inclusion of depreciation and amortisation into valuation tell us how much the companies need to incur the replacement cost. It tells us which industry require heavy replacement cost. This brings me to next two quotes:
“Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us.”
Warren Buffett, Shareholder Letter 2007
"Loomis: In your 1987 Letter to Shareholders you mentioned that Berkshire liked to invest in companies requiring only small amounts of capital. Now you are investing in companies with large capital needs. Why this change?
Buffett: Companies with little need for capital are harder to find. Berkshire Hathaway Energy and BNSF Railroad require lots of capital. We earn decent, but not extraordinary returns on capital.
Munger: When circumstances changed, we changed."
Berkshire Hathaway Annual Meeting 2016
Most consumers and business-driven software manufacturers are switching from direct purchase (before 2010s) to monthly subscription (in 2010s and in the future). It appears to me that depreciation has replaced by subscription costs. With internet of things and cloud computing, many businesses and consumers don't have to buy entirely new software for the sake of new features. The new features are automatically added from time to time - it is very noticeable if you have used Intuit's Quickbook Online. Sadly, I have not made an investment in Intuit stock - I am just too slow to recognise that it has led to huge revenue incremental over few years.
To sum these above up, it pays to be careful and prudent to reserve cash for the replacement cost in order to maintain the growth of the company. Meanwhile, I will have to shop for new speaker when I have time to do so.
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