Understanding Depreciation: 4 Depreciation Archetypes
A lot of investors don’t give depreciation enough thought. Whenever you compare P/E ratios, you are – to some extent – counting on depreciation between companies being totally comparable.
It’s not.
Forget loans for a second. And forget the idea of “appreciation” and “depreciation” in the sense of a rise or fall in value. Instead, we’re just going to talk about depreciation and amortization as they are used in financial statements.
We’re talking 10-Ks and 10-Qs. We’re talking balance sheets and income statements.
We’re talking accounting.
For our purposes, the words depreciation and amortization mean the same thing. It’s just that we’re going to say depreciation when we’re talking about something we can touch – like a cruise ship. And we’re going to say amortization when we’re talking about something we can’t touch – like a management agreement.
Otherwise, depreciation and amortization are synonyms.
You sometimes hear it said that depreciation is a reserve for the replacement of an asset. That’s wrong. Depreciation is a method used by accountants to spread the cost of an asset over the period in which the asset provides a benefit to its owner.
Basically, we’re talking about matching the costs and benefits – the revenues and expenses – of an asset so they appear on the income statement at the same time.
The basic idea you need to get from reading this article is that no one is attempting to account for the replacement cost of the asset when they determine the depreciation expense. Replacement cost has nothing to do with depreciation.
Instead, they are taking the cost – the expense – of what you are buying today, and then chopping it up and spreading it out over the time you use it.
If you want to think of the difference between buying a car and renting a car to understand depreciation, that’s fine. If you rent a car, you get charged every day. If you buy a car, you get charged once (but it’s a big charge). In a sense, depreciation is about providing the folks who read financial reports with a picture of a business’s performance that shows the car buyer in much the same way it would show the car renter. Each day we’re asking: what did it cost the driver to use his car today?
That analogy is far from perfect. And I’ve made things sound simpler than they really are. But, now, I’d like to move past talking abstractly about depreciation and amortization and move to talking about specific examples you will see in your investing adventures.
I’ve singled out these 4 stocks because they are examples – in fact, rather extreme examples – of 4 types of important depreciation situations you’ll come across when you research stocks.
In a sense, these 4 stocks are archetypes of situations in which depreciation and amortization can be important in picking stocks.
Although I said depreciation is used to match the timing of the expense of owning an asset with the benefits …
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