Security Analysis: Depreciation and amortization charges from an investor’s perspective

This excerpt is taken from the book “Security Analysis” by Benjamin Graham and David Dodd. It is regarding amortization and depreciation charges and the pitfalls in these numbers:

Rule 1: The company’s depreciation charges are to be accepted in analysis whenever (both):

a) They are based on regular accounting rules applied to fair valuations of the fixed assets; and

b) The net plant account has either increased or remained stationary over a period of years

Rule 2: The company’s charges may be reduced in the analyst’s calculations if they regularly exceed the cash expenditures on the property. In such a case the average cash expenditures may be deducted from earnings as a provisional depreciation charge and the balance of depreciation included as part of the obsolescence hazard, which tends to reduce the valuation of this average cash earning power. The obsolescence allowance will be baased upon the price paid for the enterprise by the investor and not upon either the book value or the reproduction cost of the fixed assets.

Rule 3: The company’s charges must be increased in the analyst’s calculations if they are both less than the average cash expenditures on the property and less than the reserve required by ordinary accounting rules applied to the fair value of the fixed assets used in the business.

What they are discussing over here deals with the idea that most property plant and equipment do not just wear and tear (per the amortization charge per year on the income statement) and it is hardly ever the case that companies will have sufficient cash and resources to construct a new plant after the useful life is over. In most instances factories do not actually wear out; they become obsolete.  And that is a business hazard which is not captured by the income statement.


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