In this chapter we take a closer look at amortization and how, as investors, we should look at it.
While the cost of a company's assets serves as the appropriate basis for computing depreciation, this is not the case for the investor, because the investor is buying these assets at a different price than they cost the company.
The book value of an oil company is $35 million, but the stock was priced so that the investor would be paying $88 million, then the investor would be paying $53 million more than the book value. The oil company receives revenue from oil royalties, but it also has oil holdings still underground. The company carried the holdings at no value on its balance sheet, so it did not amortize them. The investor, however, in actuality, is paying $53 million for the holdings, so he should properly amortize the oil holdings.
Another oil company carries producing leases, and the company is earning $3.44 per share. An investor would be paying $34 million more than the book value of the company. It is possible that the company's nonproducing royalties and undeveloped leases, which cost $2.6 million, are worth much more than that, enough to make up the difference. However, this is a very speculative operation, so the investor should mark up the depletion charge to include the $34 million, which reduces the earnings to practically nothing.
A counterexample: A coal company's stock was $9.30 per share, but the net current assets were $20.50 per share. An investor would be getting the plant account for free, so he need not be concerned with the amortization.
It appears that the company's own amortization charges are irrelevant, and the investor should always do his own calculations. While this is true in a strict sense, in most cases the earnings would not be affected this significantly by any changes to the company's amortization charges; the company's charges are usually close enough that an investor need not make his own calculations.
An investor should always pay attention to the value of the fixed assets - the company's amortization charges should be looked at in relation to the value of the fixed assets implied by the stock's current price. If the stock's price is considerably above book value, then the investor can assume he is paying for the present replacement value of the fixed assets, in which case, he would calculate depreciation based on this present-day value instead of the lower original cost.
Of course, the present-day replacement value should replace book value, but no more. If the stock's price is still higher than the value of the fixed assets after the present-day adjustments, then the balance can be ascribed to goodwill or some intangible asset.
Like stated earlier, if a stock's price is less than the working-capital alone, then the investor would not use any depreciation. But, he must not ignore it and count it as additional earnings, because the company may use this for replacing fixed assets or expansion over the years.
Expended depreciation is just this - when the investor reduces depreciation to a figure approximating the replacement/expansion costs, over about ten to fifteen years in the difference would then go into surplus earnings, to benefit the stockholders. To find the expended depreciation, the investor should subtract the decrease in the net plant account from the total depreciation charges for the period. Be sure to include any substantial sales of property or write-downs charged to surplus (added back in to the plant account) before making this calculation.
An example would be a company who's depreciation charges ate up all the reported earnings, but the stock price was at a level where the investor was paying nothing for the plant accounts. He would reduce the depreciation figure to the cost of replacement/expansion, and the balance he would realize is accruing to the stockholders.
Obsolescence is a type of depreciation, but it is more properly thought of as an adverse business development which affects the earnings potential of the company.
Companies have a trick, where they devalue an asset to a low price, say $1, in order for them to save the depreciation charges against income. This leads then to companies with high value assets being worth less than an identical company but with low value assets, because the depreciation charges are higher for the high value assets. This is absurd, but makes sense on Wall Street. This can lead to radically different earnings reports, which will affect dividends (if a company "doesn't make any money" then it cannot pay dividends). A businessman would determine the reasonable value of the companies by examining their assets and charging only necessary depreciation.