How To Treat Depreciation In Valuation

How To Treat Depreciation In Valuation

Depreciation is a non-cash expense. Of course, we all know that, but can we ignore it?

For example, if i buy a machine for $1 million, the lifetime for the asset is ten years. Thus, i can expense $100k every year in my income statement and claim tax deductions (tax authorities use accelerated depreciation rather than a straight line). The inherent assumption is that we must replace the machine after ten years or spend $100k on annual maintenance.

Per accounting, the following changes happen:

1)Depreciation expense of $100k in PNL for the next ten years

2)$100k subtracted from Gross block and added to depreciation liability account in the balance sheet

3)$1 million as cash outlay under the investments section of the cash flow statement

Thus every year, accountants report a $100k reduction in earnings for the next ten years but no changes in cash outlay in the cash flow statement.

I have observed #investmentbankers and #privateequityfirms exploit the above methodology by adding back depreciation to develop #EBITDA, which they infer as operating cash flow. Then, using this terminology, they raise additional debt, especially when they do leveraged buyouts.

The bankers imply that they need no capital to maintain or replace CAPEX. As a result, firms that increase their debt burden cannot make any additional CAPEX reinvestments, thus impacting their growth. I observed most companies that closed in 2020 due to COVID exhibiting the above trend.

Thus, analysts investing or evaluating acquisitions should treat depreciation as an expense in their earnings calculation. The same applies to goodwill and amortisation.

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