As I said last year, Warren Buffett’s annual letter to Berkshire Hathaway Inc. (NYSE:BRK.A) shareholders is on my must-read list, and I suggest adding it to yours as well. His letters always provide investing insights written in Buffett’s folksy but outspoken manner. This year’s letter was no different. Though the media focused on the what the “Oracle of Omaha” said about productivity and the U.S. economy, a significant portion of the commentary was devoted to how earnings and assets can be misstated.
This may sound like heady accounting stuff, but it has implications for how you view a company’s earnings and its balance sheet. An understanding of how assets, shareholder equity and earnings can be overstated (or understated) will help to you know when to be skeptical of the metrics a CEO wants you to focus on.
There are two big types of noncash charges you will see. I’ll start with depreciation and then move onto amortization. Depreciation is a charge taken to reflect the decrease in value a physical asset incurs. For example, say a firm buys one of its new employees (Jimmy) a cocobolo desk. Accounting rules require that a certain percentage of that desk’s value be deducted each year. These charges count against earnings, but because checks are not being written to cover the charge, the charges do not count against cash flow. Depending on how gentle or tough Jimmy is on the desk, it may retain or lose more value than the depreciation charges imply. I’ve seen fully depreciated assets that could be still be sold. On the other hand, depreciation can understate the amount a company has to truly spend on equipment and machinery. As Buffett observed: “The depreciation charge we record in our railroad business falls far short of the capital outlays needed to merely keep the railroad running properly.”
Amortization charges are charges taken to reflect the decrease in value of intangible assets. Software is a good example. Over time software depreciates in value, even though no checks are being written to cover the cost.
You may also see charges for the impairment of goodwill. Goodwill is the premium paid to acquire another company. The problem is that goodwill is a fuzzy asset. If a larger firm acquires Jimmy’s business, it may or may not be able to take advantage of Jimmy’s relationships with clients. The problem with accounting rules is that they recognize the decline in value of intangible assets, but not the potential for an increase in value. A smart acquisition that truly recognizes synergies can result in earnings far in excess of the goodwill recorded on the balance sheet. Accounting rules do not allow this appreciation to be recognized. (Shareholder equity may grow through the retention of the extra earnings, but that’s a different conversation.)
Put another way, here is what Buffett wrote: “For software, as a big example, amortization charges are very real expenses. Conversely, the concept of recording charges against other intangibles, such as customer relationships, arises from purchase-accounting rules and clearly does not reflect economic reality.”
The challenge is that, as outsiders, we don’t know what a company’s true replacement costs are or how much its intangibles are worth. As a general rule of thumb, it’s best to assume replacement costs are underestimated by depreciation expenses and the value of the intangible assets including goodwill is overstated. (You can also assume goodwill is understated if the company has a good, long-term record of turning acquisitions into actual sources of revenue and earnings growth. Such companies tend to be the exception and not the rule.) Buffett gives some guidance for Berkshire shareholders (of which I am one), but even his advice is inexact: “To embrace reality, however, you should remember to add back most of the amortization charges we report. You should also subtract something to reflect (Burlington Northern Santa Fe’s) inadequate depreciation charge.”
This haziness should give you reason to ignore CEOs who want to you to look at EBITDA (earnings before interest, taxes, depreciation and amortization). This number is neither a company’s profits nor its cash flow. It is a number the CEO thinks will make his or her company’s performance look better. (Buffett advises that “when CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.”) Do yourself a favor and look at the actual earnings. Then look at the cash flow statement. You may find a story that is different than what the CEO wants you to believe.
I’ve long struggled with intangible assets—including goodwill—when it comes to valuing companies based on their book value. I fret about them being inflated and I generally just don’t trust the reported figures. One solution I’m leaning toward is to require a certain level of asset turnover. The asset turnover ratio is revenues divided by total assets. This ratio reveals how effectively a company is turning assets into sales; it rewards companies whose goodwill is understated and penalizes companies whose goodwill is overstated.
As far as depreciation is concerned, it can be helpful to look at capital expenditures on the cash flow statement. By looking at the amounts recorded over a period of years, you’ll get an idea of how much is actually being spent on property and equipment.