What is depreciation? And why is it such an important thing for investors to watch?

Whenever companies report earnings before depreciation, interest, taxes and amortisation (EBITDA), many investors may be wondering what is depreciation? And is it worth paying attention to at all?

In this article, we will answer those questions.

What is depreciation?

Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. It represents the reduction in the value of a tangible asset over time due to wear and tear, usage, or obsolescence. Tangible assets can be anything tangible other than land because land (theoretically) does not go down in value – buildings can and do go down, but not the land itself.

Tangible assets can be infrastructure, computers, furniture at the company’s offices or motor vehicles just to name a few. Intangible assets do not undergo depreciation – they undergo amortisation instead, which may appear to work similarly, but amortisation is its own practice.

Depreciation allows companies to spread out the expense of an asset over the period it is expected to be used, rather than taking the entire cost as an expense in the year the asset is purchased.

How it works

There are several methods of calculating depreciation. The most common is straight-line where an asset’s cost is evenly spread out over its useful life. Following this is the so-called ‘declining balance method’ where the asset in question is depreciated more in the earlier years of its useful life. This method applies a fixed percentage to the book value of the asset each year.

Other (less popular) methods include the Units of Production Method where it is based on the actual usage of the asset, such as the number of units it produces or hours it operates.

Why should investors care?

Depreciation is important for investors in stocks to pay attention to because it has several key implications for a company’s financial health, performance metrics, and valuation. You may thinking about the E word ‘EBITDA’. Given EBITDA is earnings ‘before D&A…’ it shouldn’t be relevant at first glance.

But it does impact a company’s profit (typically called net income by US companies using GAAP principles), and naturally the gap between EBITDA and profit. For companies that prefer EBITDA as a metric, especially when the company’s ultimate profit is actually a loss, depreciation may make a company look better than it is. While it doesn’t involve an actual outflow of cash, it does reduce reported earnings, which can influence investor perception of profitability.

Another thing to consider is that because depreciation is a non-cash expense, it is added back to net income/profit in the operating cash flow section of the cash flow statement. High depreciation can lead to lower reported earnings but strong cash flow. Cash flow is crucial for assessing a company’s ability to generate cash to reinvest in the business, pay dividends, or reduce debt. So a business’ choice to chop off a percentage of value to an asset could make its cash flow look better than it is.

Naturally, depreciation affects the book value of the assets themselves. So it may affect metrics like P/NTA or Price to Book. Investors often look at these metrics to assess whether a company’s stock is trading at a premium or discount to its intrinsic value and make buying or selling decisions on account of these – although it would not be wise to make it just based on this single metric – or any one metric for that matter. A higher level of depreciation may make this metric higher than it is and make the company appear overvalued.

Turning back to cash flow, a company with significant depreciation expenses might need to invest heavily in capital expenditures (CapEx) to maintain or grow its operations. Investors should compare the two figures in order to understand whether a company is merely maintaining its asset base or expanding it. Persistently high depreciation with low CapEx could signal underinvestment in the business, which might affect future growth. Or it may indicate ‘cooking the books‘.

And finally, depreciation has tax consequences. It reduces taxable income, which can lower a company’s tax liability. Typically it is not the case that the company can claim a dollar back in the form of tax refunds for each dollar of depreciation, but it can be applied to reduce taxable income. Investors should consider how a company’s strategies towards depreciation can affect its tax burden and overall profitability.

It is more important than you thought

In summary, understanding depreciation is essential for investors as it affects key financial metrics, cash flow, asset valuation, and the overall financial health of a company. Investors who pay attention to how depreciation is managed have an advantage over investors who do not, if they know how it can influence a company’s cash flows and profit.

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