Fructivore Investments

A great deal of analysis is devoted to ferreting out a company’s true earnings. It may be necessary, for example, to adjust asset impairment costs if the reality is not that the assets suddenly became impaired but that the company overpaid for them to begin with. Benjamin Graham’s Security Analysis devoted a significant number of chapters to recasting financial reports in a way that is more useful to analysts.

One common item to consider is the excess of depreciation charges over capital spending, if any. Depreciation, although it is charged against earnings, does not entail any cash expenditure. Therefore, excess depreciation constitutes additional earnings to the equity holder.

However, in order to count the excess depreciation as free cash flow, investors must assure themselves that the company is not shortchanging its capital expenditures, which will result in diminished earning capacity. During the junk bond era, many analysts used EBITDA, earnings before interest, taxes, and depreciation, to determine just how much debt a company could carry, but unless the company requires no additional capital expenditures (unlikely), it is simply liquidating itself in slow motion. The correct measure is earnings before interest, taxes, and the net of depreciation and amortization over anticipated necessary capital expenditures, but EBITNDAOANCE is harder to pronounce.

To illustrate this situation, in 2008 Qwest Communications took a charge of $2.354 billion for depreciation but made only $1.777 billion in capital expenditures. This excess has persisted over several years back, and is suggestive of a business with a high initial startup cost and a lesser capital maintenance requirement, and in Qwest’s case it causes the PE ratio to drop from 10 to 5 and a half. However, as stated above Qwest may be slowly ratcheting down the scale of its business, and indeed its operating earnings and its number of subscribers have declined in the last few years, although since less than half of its earnings come from its mass market services the gross number of subscribers may not be dispositive. At any rate, when a company can legitimately squeeze extra cash flow out of its depreciation, its owner has a claim to more income than the reported earnings alone indicate.

Filed under:
Investing by grocca