From a purely accounting standpoint, the answer to “is depreciation an expense” is that yes it is, both in the income statement and the cash flow statement (as a sort of credit).
However, the answer to the question “is depreciation an expense I can ignore”, or “is depreciation an expense, and does that mean EBITDA is basically accounting shenangains”, is much more difficult to answer.
After all, there’s been strong opinions against EBITDA:
“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge.”–Warren Buffett
“I think that, every time you see the word EBITDA, you should substitute the words “b***s*** earnings.”–Charlie Munger
Contributor Cameron Smith also had a great post questioning EBITDA, and had a similar conclusion to Buffett and Munger.
Yet many investors also swear by it, and as an extension largely ignoring depreciation in their analysis of earnings, as it’s continued to be used by managements in many different public companies.
Senior analyst Brad Erickson had this to say about non-GAAP measurements like EBITDA:
“Most investors out in the marketplace today do rely on non-GAAP figures, given stock-based compensation is a non-cash expense”
In a snide reply to Buffett and Munger, he also added this:
“If Charlie Munger wants to say it, that’s cool. “I’d say that’s probably why they didn’t buy Amazon or Facebook.”
I’m not hear to proclaim a definitive judgment one way or the other with regards to this. Rather I want to make the argument for both, as both ways can be useful, and most importantly, it’s vital for investors and analysts to completely comprehend how depreciation fits into the 3 financial statements, and when and why it matters at certain times rather than others.
The Answer Requires a Deep Dive of Depreciation Expense
With this post, I’ll present both cases in defense and against EBITDA (and by extension, depreciation expense).
But first, let’s look at the basics of depreciation expense.
We’ll use a couple of examples from real-life companies and their 10-k’s, with companies that make it easy, and not so easy, to find depreciation expense and how it ties with all of the numbers. But you’ll always be able to find it, if you look hard enough.
Then, I’ll discuss the merits behind why an investor would ignore depreciation as an expense, and then also present why an investor would take the opposite stance and dismiss EBITDA.
Finally, I’ll give you a great takeaway so that you can use the best of both worlds, and be better equipped to answer whether depreciation as an expense should be considered in your analysis.
Where To Find Depreciation in the 10-k
What can get confusing is that sometimes you can find depreciation in the income statement and sometimes you can’t, but you will always find it in the cash flow statement (and should be able to find it in the footnotes of the 10-k).
Finding Depreciation in the Income Statement
Some companies have blessed investors by making their financial statements so simple as to place depreciation directly on the income statement as its own line item.
One such example is Exxon Mobil– a company with a large proportion (over 65%) of their total assets as Property, Plant and Equipment– which displays Depreciation and depletion under the Costs and other deductions section in their Consolidated Statement of Income.
Finding Depreciation in the Footnotes
Let’s take Facebook as an example, where depreciation is not explicitly stated in the income statement. Their income statement shows the following:
Doing a ctrl+f search for “depreciation”, I find notes about depreciation in Note 6: Property and Equipment, where the following is disclosed:
“Depreciation expense on property and equipment were $5.18 billion, $3.68 billion, and $2.33 billion for the years ended December 31, 2019, 2018, and 2017, respectively. The majority of the property and equipment depreciation expense was from network equipment depreciation of $3.83 billion, $2.94 billion, and $1.84 billion for the years ended December 31, 2019, 2018, and 2017, respectively.”
As the company disclosed that most of the depreciation was due to their network equipment ($3.83 billion) it seems reasonable to assume that the depreciation could be embedded either in Cost of Revenue or General and administrative line items of the income statement.
We won’t always know for sure, but at least we know how to find the depreciation number.
Now, comparing this to the Depreciation and amortization line item in the Cash Flow Statement, which will always be reported, we can see the following:
The total there for 2019 is $5.731 billion, which falls in-line with the number found in the notes above, $5.18 billion. It’s safe to assume that the remaining difference between $5.731 billion and $5.18 billion can probably be attributed to amortization (of an intangible asset), or some other depreciation not included in PPE.
Note: Amortization is tricky because the rules around goodwill amortization has changed, where before companies would amortize all goodwill over a set number of years (like depreciation); now companies perform goodwill impairment tests and take a large charge if the asset is determined to be overvalued.
Depreciation is an Expense to Ignore (or, “It’s Not”)
As it pertains to investors who are trying to either…
- Find an opportunity that’s undiscovered due to a Wall Street misunderstanding of its depreciation
- Or, avoiding managements who are manipulating depreciation and EBITDA to hide expenses
Really an astute observer of financial statements can do both with close examination.
Let’s present the “bullish” case for both– either depreciation is undoubtedly an expense and EBITDA is worthless, or depreciation isn’t an expense and represents great cash flows to come.
The “Depreciation is an expense” argument
Let’s say cash flows are depressed because a company is aggressively spending in capex to grow the business (This can also be hidden by using large debt, leading to large cash flows AND large capex spending, and thus large depreciation).
We should know that rationally, a company can’t grow forever. And so at a certain point, what investors want to see is a company that grows until it matures, at which point capex is no longer needed and the large free cash flows can be distributed to investors.
The problem is when a company needs to continuously spend on capex just to keep itself afloat (or growing). In other words, if the capex (and depreciation) stops, then so does the music.
Well, now all of a sudden EBITDA doesn’t mean much, does it?
If capex spending decreases and this causes future earnings to fall, then that means old capex wasn’t very effective in producing sustainable cash flows.
In that case, all of the talk in all of the previous years with EBITDA means nothing, because those past “EBIT” were fueled by the “DA”. In other words, recurring capex is a major part of this (capital intensive) business, and so you can’t ignore future depreciation because it will be a recurring feature (and expense) of this business (and its future earnings).
Contrast that with the other possibility…
The “Depreciation isn’t an expense” argument
Now, let’s take a business that’s making strategic capital expenditures to scale the business.
In other words, a business can make very strategic capex outlays, which will either result in superior returns and/or sustain cash flows for a very long time.
An example: Facebook. Let’s take the rewind machine and pretend they didn’t have operations in the Philippines yet.
Well, what would it take for Facebook to expand to a new market with their business model? They’d have to build a network first, which might take some upfront spending on marketing (which probably won’t be depreciated but instead show up as a large marketing expense). They’d have to build or buy data centers or technology infrastructure to support the needs of users there. That’d fall under capex and would be depreciated over years with GAAP accounting.
However, consider whether that buildout is permanent or temporary, and whether it needs a lot of capital to build or maintain.
Just from a high level perspective it doesn’t seem like much more recurring capex would be needed for Facebook to grow or sustain this new market, and this should make us think of depreciation differently.
In other words…
If Facebook reported EBITDA in previous years before this one-time expensive expansion, the point might actually be pretty valid. After all, the large deprecation expenses they were taking aren’t supposed to be a recurring feature of this business. It was just there to spark scalable growth, which would take a lot less capital (and depreciation) to continue for the foreseeable future.
Now EBITDA becomes very useful, because investors can understand that although the financials might look awful from a GAAP standpoint now, the depreciation down the road shouldn’t be as high as it is right now, until EBITDA over the long term will eventually look like Net Income anyways.
How to (Potentially) Find Opportunities With Depreciation and EBITDA
Now let’s take this theory into a deeper accounting level.
I’m going to take a shade of gray to the discussion, and present two more examples where we can intelligently look at depreciation and apply it to an observation about the company (and possible investor perceptions).
I think a major potential pitfall to taking depreciation from a qualitative level (like my Facebook expansion example) is that it could contribute to blissfully high investor expectations that are biased in one way or the other.
And, while extreme examples work great as a concept, analyzing stocks in the real world isn’t always nicely black-and-white like theory is.
Depreciation Examples: Two Different Applications
Depreciation expense on the tail end: Looking through footnotes or sections of the 10-k, combined with an examination of previous capital expenditures, could help immensely in determining future expected depreciation expenses to the income statement.
Let’s take an aggregate mining company, for example. Here’s the expected depreciation of their various PPE investments:
Knowing this, an astute analyst might be able to identify depreciation that’s about to fall off and produce a jolt to earnings.
As an example, if the company made a large capex 4 years ago, and the expected life of the factory/plant/machinery is 5 years, well then its likely that next year’s earnings will have that last depreciation charge, then year 6 will have earnings free of depreciation.
Reading the footnotes should provide valuable information on how aggressively management is depreciation certain PPE assets, which could help an analyst in determining when that depreciation is about to fall off.
By confirming higher profitability with attractive past EBITDA, an investment in an environment like this could be a quick jump in GAAP earnings, and better valuations.
Fresh depreciation expense: Take the scenario where a company just posted a disastrous quarter and was hammered. Maybe they lumped all of their bad news together, just had terrible operating results, took a large impairment, had bad timing with stock-based compensation, whatever.
In this case, investors might be much less inclined to trust adjusted EBITDA numbers from management, which could create an opportunity for the studious investor looking for a margin of safety.
If you feel like you really have a mastery on a company’s industry or business model, and are willing to trust the company’s current or adjusted EBITDA based on your own analysis, then there could be alpha there if/when investors finally catch up to the idea of EBITDA eventually reaching real GAAP EPS and value the company accordingly.
Knowing the intricacies behind depreciation and EBITDA can be another useful tool under your belt for analyzing financial statements, but only if you understand the context and extent of its usefulness.
Unfortunately with investing, a lot of important concepts are quoted in a catchy phrase one way or the other, and often with a huge lack of context.
As you learn more and more about markets and financials, keep in mind that it doesn’t cost much to learn what you don’t already know, before assuming that popular opinion is the one and only choice, one way or the other.
In the case of depreciation, of course it’s an expense in the income statement. But whether you take it as a positive or negative in your analysis, well… it depends.
It’s my hope that you take a step-by-step approach to mastering the financial statements and expanding your circle of competence, like Charlie Munger said:
“Go to bed smarter than when you woke up.”