Understanding Depreciation

Depreciation is a charge on the assets of the company to reflect the loss of assets through wear and tear or obsolescence.  While in accounting terms it would simply writing down the value of an asset annually by a fixed percentage generally in line with what the income tax authority’s numbers.
Meaning Depreciate as per Webster:  to lower the price or estimated value of

However, what is relevant depreciation is can be clearly defined by economic depreciation…meaning a charge that will provide for the replacement of assets (and the earning power) in place of the current assets. This is the point where accounting and economics start to show a wide gap. While accounting is in favor of charging the book value of an asset with a regular amount, the actual earnings power or cash flow is never taken into account.

Then, what are the implications for company’s accounts whose market value of assets is far higher than what is carried on books. Well the standard argument would be since the value of an asset is the present value of the cash flows that can be generated by the asset, in case the market value of an asset has increased, it would reflect in the cash flows (earnings) of the company.

Let’s assume to scenarios of High asset value:

Asset value is high
For example: A company with a gold mine.
With gold prices spiraling and touching new highs, the company market value of asset would be far higher than what would be reflected in the books. While the increase in value of the asset would be analyzed and reflect in the earning’s and due weightage is likely to be given by the Analysts over a period of time. The immediate appreciation of such a gain due to holding of high quality, high earning assets in Books is frequently ignored. This is mainly due to the trouble of analysts in revaluing the assets and related entries which at the times the market would not appreciate terming it as very aggressive.

This was seen when the carbon credit story played out in the news. While the Carbon credits gave an incrementally high value to the Fixed Assets of some of the companies, analysts took considerable time in appreciating the same. SRF was a case in point.
The lack of clarity of on Pricing of carbon credits, made certain analysts vary of the projections based on assumption and appreciating the true potential.  (I have no personal opinion on the carbon credits pricing or any view on how it would span out)

However, one learning that I got on observing this was relatively complex ideas remain under researched and analysts relatively take very conservative (to avoid being completely wrong) opinion and there is a possible of unearthing huge value based on thorough analysis.

A thought: “Equity Analysts estimates of calls on stock would be far more worth if there was no active stock price being quoted in the stock markets. Something that clouds over the mind before sitting on any fair value analysis.

Financial statement analysis will not easily help in finding the actual hidden value of assets. At best hidden value in assets may reflect in lower charge of depreciation in relation to income. Analysts and owners have to maintain their conservative approach and seldom right up assets.

What happens if no adjustment to the asset value and depreciation is made?
Reported Earnings for the year will be reported higher due to a low depreciation charge. Hence all earning ratios (P/E, ROE) would look good but Book value ratios would not look attractive.  

Godrej consumer products is a case in point.
The company currently trades 23 times its TTM earnings and 51 times its book Value.  The actual value of the asset is in the Brand (something very true with strong franchises). The company’s depreciation is just 8% of its operating profit.
While I generally look at book value business  ...in this case it was just not possible as the value of the brand is to be added on to the book value.

However, accounting for appreciation or depreciation of assets does not change the cash flows and any valuation done on the cash flow would hold good.