Depreciation, amortization and depletion are all essentially the same concept. In all three cases, you are spreading out the value of some asset over its useful life. Depreciation is used for tangible assets like hardware, trucks, machines etc. Amortization is used for intangible assets like patents. Depletion is used for natural resources for example a coal mine an oil well, etc.
In this article, I am going to focus on the accounting treatment of depreciation and how it can distort reported earnings for some companies. I am also going to talk about how Buffett calculates the real economic earnings of a business.
In the 1986 Berkshire annual letter, Buffett outlined his definition of real economic earnings which he called the owners earnings as:
Reported earnings + depreciation, amortization, depletion ± other non-cash charges – normalised maintenance CapEx
Depreciation, amortization and depletion are all theoretical expenses that don’t involve any actual flow of cash. These non-cash charges can distort the reported earnings because small changes in the useful life of the asset can have a big impact on earnings. For example, the useful life of aircraft is in the 15-25 year range. If it is depreciated using the straight-line method for 15 years, it loses 6% of its value each year whereas at 25 years, it loses 4% of its value each year. A 2% difference does not sound like much but for an airline with a fleet of planes depreciating every year, a 2% difference in annual depreciation will have a large impact on the reported earnings.
The depreciation figure is meant to be an estimate of replacement cost however for expensive long-lived assets, depreciation will almost always understate the true replacement cost because of inflation. If an airline buys a passenger plane for £100 million, in 25 years when it comes time to replace the plane with a new one, it will cost about £210 million assuming inflation runs at 3% in this period. This is more than twice the estimated replacement cost of £100 million. If inflation runs at 4% every year, the replacement cost rises to £267 million.
Amortization also distorts earnings in a similar way. If one company buys another at a premium to its book value, this excess amount is recorded as ‘Goodwill’ on the acquirer’s balance sheet. If the premium is large enough, the amortization expense will also be large and reduce the reported earnings of the acquiring company. If the acquiring company paid a premium to book value because of the purchased company’s brand, why should the acquiring company be charged an amortization expense? In real economic terms, a brand developed internally is identical to a brand acquired by purchasing another company, but accounting rules treat them differently and this could lead to economic earnings being understated.
To remove the effect of effects of these non-cash charges, depreciation and amortization are added back to the reported earnings. Now the maintenance CapEx is the amount of actual cash the company needs to plug back into the business to maintain its competitive position. For an airline, this will vary from year to year. In some years, it will simply pay for routine engine maintenance but occasionally, some planes may need significant upgrades. What you want to determine is the normalised capital expenditure over a cycle. This number can’t be precise because of the uncertainties involved in making such an estimate. However, you can’t simply use the latest CapEx figures in the cash flow statement because these can under or overstate the actual amount the company will invest in a normal year. In our airline example, if the company is increasing the number of routes it offers, it may need to buy more planes. In any year where it makes such a purchase, the reported CapEx will inevitably be higher than in a normal year where it simply uses CapEx to maintain its current fleet. A good estimate would be to find the average or median over the last 5 years.
As Buffett said in his 1986 annual letter, the job of the accountant is to record not evaluate. Investors must use common sense to understand whether the accounting accurately reflects reality and using owners earnings is a much better estimate of the true economic earnings of the business.