S&P downgrades Japan: a cautionary tale?

the S&P downgrade

Last week Standard & Poors downgraded the sovereign debt of Japan, reducing its rating on the Tokyo government’s bonds by one notch, to AA- from AA.  In doing so, S&P cited:

–high government debt ratios

–persistent deflation

–an aging population and shrinking workforce

–social security expenses at almost a third of the government budget, and rising

–the lack of a coherent plan to address the growing debt problem, and

–the global recession, which has worsened the situation.

With the possible exception of the last point, none of this is exactly news.  S&P could have cited all the other factors five years–or even ten years–ago.

What’s going on?

Two things, in my opinion:

1.  The Liberal Democratic Party, the dominant force in Japanese politics for the past fifty years, was tossed out of office in a landslide victory for the opposition Democratic Party of Japan in August 2009.  This happened once before, in the late 1980s, when the Socialist Party, from which the DPJ springs, did the same thing.  On both occasions, the transfer of power was followed by heavy-duty partisan infighting within the winning party, stunning ministerial ineptitude and legislative paralysis.  The past eighteen months have demonstrated that chances of another charismatic leader like Prime Minister Koizumi of the LDP emerging from the current fray are pretty remote.

2.  There’s a business cycle pattern to changes in the credit agencies’ ratings.  While the globe is expanding, the agencies’ ratings lag the economic reality.  They end up being too bullish for way too long.  In contrast, after having been castigated by the regulatory authorities and the markets for this behavior, the agencies become excessively cautious.  They downgrade aggressively and actively search for high-profile instances to do so, in order to tout their new-found conservatism.  Once the economic cycle turns up, of course, the rating agencies have tended to quickly forget this prudence and resume their former generosity to client bond issues.

no market reaction, but lots of expert commentary

Since the ratings downgrade contains no new insights into Japan’s malaise, the reaction from financial markets has been ho-hum.  But pundits have seized on this chance to air their views.  Internal commentators have been beating the drum again for economic reform.  External ones have reiterated their stance that Japan today is a look into the future for the US if we don’t mend our ways.

my thoughts, too

Since everyone else is doing it, I thought I’d also give my views about Japan (yet again), based on my twenty-five years of experience in the Japanese equity market.  Here goes:

1.  Reform just isn’t going to happen.  For decades, Japan has followed a policy of preserving the status quo, even at the cost of no economic growth.  The result has been that creative destruction, where a new generation of firms rises from the ashes of the old, isn’t allowed to happen.  Weak and inefficient entrants in an industry aren’t compelled either to change their ways or fail.  They receive explicit and implicit social protection instead.  So they drag down the strong.

2.  Perversely, the economic stagnation and mild deflation that result from this policy help perpetuate the system.  Lack of economic growth keeps interest rates low. Domestic investors have few viable investment alternatives, so they continue to put their savings into government bonds.    Therefore, Tokyo can fund continuing deficits easily and at low cost.  In a funny sense, the worst thing that could happen to Japan over the next several years would be for the economy to spontaneously (it would take a miracle, though) begin to grow.  Alternatives to government bonds would arise for investors.  And interest rates would likely go up, raising Tokyo’s financing costs.  Voilà, government debt crisis.

3.  There is a point of similarity, I think, between the Japanese situation and the American that is something to worry about.

It’s not in the industrial base, which is much more dynamic and much less hide-bound in the US than in Japan.

It’s not in the politics, either, though both the Capitol and Nagatacho are to my mind similarly dysfunctional.  But the Japanese electorate has put up with legislative failure for over twenty years.  I think, however, as Americans work out that Washington is not meeting its needs, change will come swiftly and dramatically.  We’ve already seen some of this twice within a little more than two years.

One of the most striking aspects of Japan to me as an investor is the strongly held belief in that country of its cultural and economic superiority over everyone else.  The fact of this belief isn’t so surprising.  Every major power seems to think more or less the same thing about itself.  Certainly, the US does, too. But in Japan, sort of like in France, its intensity stands out.  Neither seems to me to have a sense of perspective/humor about itself. (I’ve been told, for example, by a Japanese CEO in a face-to-face interview that he didn’t want foreigners like me holding stock in his company.  Why?  …we’re subhuman, that’s why.  Actually, he told my translator, who skipped over that part–both unaware that a “subhuman” might actually understand a little Japanese.)

If you think it’s a priori impossible for a foreigner to have anything to teach you, you can be blind to the objective situation–meaning that a sense of national pride that’s out of control will act as a barrier to beneficial change.

Although the US may have prominent individuals who believe as intensely as the Japanese/French that anything domestic is superior to anything foreign, I think most of us have a little more common sense.  Again, however, only time will tell.

brokers and standards of care: the SEC study

the report

Last Wednesday the SEC published the results of a study on the differing legal obligations of brokers and investment advisers to their clients.

The SEC’s bottom line:

–while customers are generally satisfied with the investment advice they receive, they don’t really know what standards of conduct their brokers or investment advisers are legally held to.  In addition, they sometimes mistakenly think brokers are required to perform to the same high standard as investment advisers.

–the standard of conduct for brokers should be raised to match that for investment advisers, “when providing investment advice about securities to retail customers.”

why the study?

One might think that it was driven by the realization that millions of Baby Boomers will be retiring in the US over the next decade or so.  The vast majority–government workers are the biggest exception–will not have the security of defined benefit pension plans backed by their former employers. Instead, they have the money they’ve saved in IRAs or 401ks, for which they will have investment responsibility, to support them in retirement.

That’s not the reason, though.  The SEC did the study because it was ordered to in the recently-passed Dodd-Frank Act.

broker or investment adviser:  what’s the difference?

in law…

Investment advisers are regulated by the Investment Advisers Act of 1940.

Broker-dealers are regulated under the anti-fraud provisions of the Securities Act of 1933 and the Securities Act of 1934.

Broker-dealers are specifically excluded from regulation under the Investment Advisers Act.

…and in practice

Investment advisers are fiduciaries.  In practical terms, this means three things:

–the adviser must do what’s best for the client

–the adviser must put the client’s interests ahead of his own, and

–the adviser has to make extensive disclosure of possible conflicts of interest.

Broker-dealers are not fiduciaries.  As a result,

–although brokers aren’t permitted to act in a way that harms their clients,

–they can recommend an investment that is less good than another but which provides a higher profit to the broker.

I’m not sure what the technical requirements for disclosure of conflicts of interest are for a broker.  My experience is that such disclosures are, at best, buried in the middle of large amounts of fine print and couched in language that only a specialist would understand. Goldman’s trading “huddles,” exposed in an article in the Wall Street Journal in 2009, are a recent example of differential treatment of institutional clients, not retail, but it’s still a good illustration of the broker mindset.

The huddles are weekly meetings of analysts and traders that ended up generating ideas, some of which go against Goldman’s official stock recommendations.  These trading ideas are communicated only to a few of the firm’s highest revenue-generating clients.  The official recommendations aren’t changed, so most clients continue to be told the opposite story.  (I just looked at a recent Goldman research report.  This practice is described in paragraph 25 of 30 paragraphs of fine print, covering three pages of the report’s total length of seven.).

if brokers are required to become fiduciaries, what changes?

It may be an exaggeration to say that this would radically change the fundamentals of the retail brokerage industry…but, on second thought, that may not be so far from the truth.  For example,

quality of fund recommendations

1.  Some retail-oriented brokerage houses have their own in-house fund management groups.  In many cases, the records of such proprietary funds is mediocre at best.  Yet brokers are encouraged to sell these funds to clients.  In my view, the main factor–other than the underperformance clients experience–is their greater profitability of in-house funds to the firm. If brokers were fiduciaries, presumably they would have to point out that third-party funds have better track records, or to disclose their financial interest.

2.  Brokers might have to disclose that in general no-load funds sold by Vanguard or Fidelity are a better deal that the load funds brokers sell.

3.  When you go into a brokerage office to have an asset allocation analysis done, it may be that the mutual fund recommendations that the computer spits out come only from fund groups that have paid to have their names displayed to customers–or who have agreed to rebate to the brokerage a portion of the management fee earned on shares sold.  Fund groups that decline to pay get no exposure. In other words, the fund recommendations aren’t the objective assessment they appear to be.

A fiduciary couldn’t do this without clear disclosure.  Actually, I think a fiduciary who tried to do this would be run out of town.

4.  If an individual broker does enough business with a given fund group, he may qualify to bring himself and a guest to  an all expense-paid educational seminar (including nightly entertainment),  in, say, Las Vegas, or San Diego or Disneyworld.  Has any broker ever mentioned that possibility when recommending a fund to you?

quality of stock recommendations

5.  Institutional Investor magazine publishes a yearly ranking of brokerage house research and a list of All-American analysts in each industry.  If brokers were fiduciaries, I think they’d have to tell you if, as many have, they’ve laid off most of their experienced researchers during the recession.  So they have no ranked analysts anymore.  And the report you’ve just been handed recommending XYZ Corp as a “buy” was written by a replacement who only has six months experience, no formal training in securities analysis, and is learning to do research on the fly.

All of this would be a little like watching your meal being prepared in the kitchen of a restaurant that probably won’t pass health inspection.  Certainly, brokers don’t want to be forced to allow you this peek under the covers.

are any changes likely, based on the SEC findings?

I doubt it.  Opposition from “full service” brokerage houses would be too great.  It’s also interesting to note that, while the study was done by the staff of the SEC as Dodd-Frank mandated, its conclusions weren’t endorsed by the SEC.

But this did give me another chance to write about some of the less obvious practices of the retail brokerage industry.  So at least that’s something.

subscription services: good or bad as stocks?

subscription services

Everyday life is filled with examples of subscription services.  They range from newspapers and magazines, where one pays in advance for copies that are delivered over, say, the subsequent year; to monitoring services that guard against burglary or fire; to cellphones, where the network operator offers a handset at a subsidized price in return for the customer signing a long-term contract; to cloud computing, where a customer “rents” storage space or other hardware, or software tools to run his enterprise.

All these kinds of companies have common characteristics.  Apart from the cost of setting up or participating in a delivery system (from coaxial/fiber optic cables to the postal or telephone service), the key variables are:

–the number of customers

–changes in that number as time progresses

–per customer revenue

–per customer operating costs

–customer acquisition costs, and

–the length of time the average customer retains the service.

These are the bare bones.  Of course, there can be other considerations, like a company’s ability to sell add-on services after the initial customer relationship is established, or the fact of general, administrative and (possibly) financing costs.  But let’s put them to the side.

my point

The point I want to make in this post is that these companies sometimes exhibit earnings patterns that equity markets find difficult to understand and value.  In some cases, this has meant that companies are ultimately taken private after their stocks have languished in price in the public markets for an extended period of time.

An example:

Consider a company that provides burglar and fire alarm monitoring to residential customers.  Typically, the firm will offer “free” installation of monitoring equipment in return for a two-year monitoring contract.

Let’s say installation expenses are 300, that the customer pays 20 per month in fees and that the average customer remains with the monitoring company for a long as he owns his house.  Assume that’s 10 years–but it could be a lot longer.  Let’s also assume that the cost of setting up the remote monitoring station is trivial, but that manning it costs 100,000 a year.

the company take on its business

The company probably does a present value calculation to evaluate how much it gains by adding a customer.  Ten years of revenues at 240 per year = 2400.  Subtract installation costs of 300 and the customer’s share of monitoring costs, say, 250.  Then the net value of a new addition is 1850.  Present value is lower, but the possibility of rate increases and operating leverage in expenses mitigates this to some degree.  Yes, I could have done a “real” calculation on a spreadsheet that would be much more sophisticated (though perhaps not much more accurate), but this is the basic idea.

the stock market’s view

Here’s what the income statement for the first five years of such a company’s existence might look like:


1 2 3 4 5
new subs% 50% 50% 20% 10%
total subs 1000 1500 2250 2700 2970
total revs 240000 360000 540000 648000 712800
op costs -100000 -100000 -100000 -100000 -100000
startup cost -300000 -150000 -225000 -135000 -81000
net profit -160000 110000 215000 413000 531800

In year 1, the company is unprofitable, even though on a present value  or “asset” basis it has added 1,850,000 in value.

In year 2, the company becomes profitable on a financial reporting basis, but still has negative net worth.

In year 3, earnings explode, even though the firm is adding less asset value than it did in year 1.

Year 4 is the really interesting one.  Reported earnings continue to rise at an astronomical clip.  Yes, profits are only up 92%, vs 94% in the year earlier.  But is this something to really be concerned about?

Actually, yes.  The concern isn’t about profits but about revenues.  In year 4, subscriber additions show a sharp drop, from 750 in the year prior to 450 in the current period.  There are two reasons the earnings are still so strong, and don’t reflect this falloff:  lower expense for new installations (startup costs) and positive operating leverage from monitoring costs being spread over a larger number of customers.

How does the stock market treat a case like this?  In my experience, the answer is “badly.”  Investors are accustomed to looking at earnings per share or at cash flow per share and this kind of company doesn’t fit either template.  While the company is expanding rapidly, the costs of linking up new customers depresses eps, and cash flow may be negative.  Paradoxically, the profit numbers look their best only when the firm begins to show signs of maturing.  But investors will begin to take fright when they see that revenue growth is slowing.

This situation is a big reason that most monitoring companies have either been taken private or are divisions of larger companies, where the unusual earnings pattern isn’t so evident.

One other observation.

This concerns accounting technique.  In the example above, the installation costs have been expensed in the year incurred.  What would the financials look like if those costs had been capitalized and depreciated over ten years.  Take a look.


1 2 3 4 5
new subs% 50% 50% 20% 10%
total subs 1000 1500 2250 2700 2970
total revs 240000 360000 540000 648000 712800
op costs -100000 -100000 -100000 -100000 -100000
startup cost -30000 -45000 -67500 -81000 -89100
net profit 110000 215000 372500 467000 523700

In the first four years, the company now looks a lot more profitable and cash flow looks better.  In other words, the monitoring company looks like a conventional firm that equity investors would have no trouble evaluating.  Expense deferral only starts to catch up with the company in year 5, when the growth rate drops off significantly.

why expense instead of capitalize/depreciate?

For one thing, expensing is the more conservative technique.  For another, in the case of a monitoring company, there’s no capital equipment.  The sensors being installed are all low-cost items that are normally expensed.  Labor cost is probably the biggest factor in the installation.

relevance for cloud computing?

As this industry develops, it will be important, I think, to distinguish between companies that rent hardware (which can be depreciated) and those that rent software (whose costs may be expensed as R&D).  Their income statements may look very different, as the monitoring case illustrates.

There may also be wide company to company differences in accounting technique for basically the same services.  More speculative firms may capitalize all the customer acquisition costs they can–and maybe some that they aren’t supposed to.  Others may have a much more conservative bent.  It’s not clear that brokerage house analysts will appreciate the differences, or flag them in their reports.

In addition, there may be firms whose financials will mimic those of the security monitoring industry.  Absent considerable shareholder education, such firms may have less positive experience for their stocks than the company performance merits.

cash flow per share and earnings per share as valuation metrics (ll): cash flow per share

investor preferences

A large number of investors in the US want to buy stocks where the underlying companies are growing profits rapidly.  The same is true in many other stock markets of the world.  For such investors, earnings per share growth is the main metric they look for when transacting.

This isn’t an immutable law of equity investing, however.  To a large degree, the search for growth is also a question of investor preferences.  In the US, the market I have the longest experience with, I’ve seen the mix of price and growth that investors prefer change dramatically several times.  This has been not so much because the macroeconomic environment has changed, but because the personal circumstances of investors (their age and wealth) did.

Also, I’ve seen other markets where preferences are quite different, where a “good” stock is one that pays a high dividend and where the company is mature enough that it has little need to spend capital on expansion.  These are markets where the search is for income, not for growth.  Taiwan in the 1980s is the first strong example I’ve encountered personally (technology stocks there couldn’t list unless they were willing to pay a 5% yield!).   But the US in the pre-WWII era seems to me to have been another.

the search for income

Not every company can grow at a rapid clip of a long time.  As well, some companies temporarily experience declining profits, either because the economy has turned against them cyclically, or because they’ve just lost their way.  In any of these cases, the large group of investors I’ve mentioned above lose interest in the stocks and more or less consign them to the equity junk pile.

There’s a whole set of other professional investors–in fact, in the US they are arguably in the majority–who evaluate stocks not on their earnings growth potential but on the companies’ ability to generate cash from operations.  There are many variations on this approach.  But all use cash flow per share as their main tool.  Such investors calculate an absolute worth for the company (usually a present value of cash flows over, say, ten years) and compare that with the share price.  They buy what they hope are the most undervalued stocks.

Around the globe, such value investors expect that at some point either the company’s fortunes will take a cyclical turn for the better, or that other investors will realize the undervaluation they see, or (in the US at least) that pressure will be brought to bear on the company to improve its operations.

[By the way, about two years ago, I wrote a series of posts on growth investing vs. value investing that you might want to read.  Take the test (which of two stocks would you buy) to see if you’ve got more growth or value tendencies.]

the stock as a quasi-bond

The key to this approach, viewing it through my growth investor eyes, is to regard the stock as a quasi-bond.

Let’s say the firm is now generating $1 a share in cash from profits and $2 a share in cash from depreciation and amortization.  That’s $3 a share in yearly cash flow.  Taking a ten-year investing horizon, the company will generate a total of $30, even with no growth at all–if the firm can get away without serious new capital investments.  If we were to assume that the company could achieve an inflation-matching rise in cash flow, then the present value of the stream of cash flow is $30.  (Yes, this is a vast oversimplification, but it is the thought process.  Remember, too, we’re also figuring there’s nothing left after ten years.)

What would a company like this sell for on Wall Street?  $20 a share?  …less?

We do have a yardstick, since if we reverse the profit and depreciation figures the description in the last paragraph is a rough approximation of INTC.  The value investor’s explanation for serious undervaluation is that people are so worried about the possibility that processors using designs from ARM Holdings will gradually eat in to INTC’s markets that they are overlooking the latter’s substantial cash generating power.

happy vs. unhappy shareholders

Another way of putting the difference between looking at earnings per share and cash flow per share–

–investors look at eps to gauge a firm’s value when they’re happy with the way the company is performing;

–they look at cash flow per share when they’re not, when they’re trying to figure out how much the company would be worth with different management, or in private hands, or after being acquired by a competitor.

The risk the first group takes is that all good things eventually come to an end.  The worry of the second group is that they’ve be unable to pry the company out of the hands of current management.

cash flow per share and earnings per share as valuation metrics (l): earnings per share

two types of investors, two toolboxes

In the US and increasingly in the rest of the world, investors tend to fall into two psychological types:

growth investors (like me) are dreamers.  We buy stocks based on the belief that future profit growth will be strong enough to make the stock rise in price.  Our mantra is:  better eps than expected for longer than expected.  We typically buy stock in well-managed, industry-leading companies and use projected future eps as our main tool.

value investors (the more venerable [read: older] school)are pragmatists.  They buy stocks on the idea that they are undervalued based on what one can see in the here and now–the earning power of today’s well-understood businesses + the value of assets on the balance sheets.  They are happy to buy a mediocre company whose stock is trading on the mistaken belief that the firm is truly wretched.  They often have an eye to change of control.  They use both cash flow per share and eps as tools.


Looking at earnings per share growth is, I think, pretty straightforward conceptually.  Earnings go up, the stock goes along for the ride.  The problem is that forecasting earnings with a reasonable degree of accuracy  even twelve months ahead is much more difficult than you’d imagine.  The evidence is that as a group even professional securities analysts, with lots of information at their fingertips and unparalleled access to company managements, fail at doing this.

One issue is that company managements understand the Wall Street game:  show surprisingly strong earnings and you’ll look like a genius and your stock (your stock options, too) will go up a lot.  So they pressure analysts to understate earnings.  Analysts, too, since their livelihood depends on investor interest in the stocks they cover, sometimes become like home town radio announcers for “their” industry and fail to notice trouble developing.

For growth investors, cash flow per share doesn’t come up in discussion very much.  For me–and I spent a little more than half my career in value shops)–three instances where  cash flow is important stand out:

–An emerging company has spent a lot on creating the infrastructure it needs to launch its products/ services, but they haven’t caught on yet.  The firm is showing small profits, or maybe losses at present.  This situation often creates the opportunity for significant operating leverage (large profit increases from small increases in sales).  So if you can find a convincing reason that the company will be successful, it is probably a very interesting investment.

–A more established company has persistently high cash flow but small profits.  This means cash flow consists mostly of depreciation.  Put another way, the company continues to make capital investments but then spends most of its time just trying to recover its (poorly conceived) outlays.  Value investors are drawn to this kind of firm like moths to a flame–thinking that either the board of directors, shareholders or activist investors will force changes.  Growth investors, in contrast, run away as fast as they can.

–A company has two divisions, one of which provides all the growth.  This happens more often than you might think.  In fact, WYNN (which I own) is in just this position.  Macau operations provide all the profits.  To my (growth investor) mind, a situation like this can provide very good performance.  That’s provided you can convince yourself that the second division–Las Vegas, in this case–won’t turn into a black hole of losses that devours the profitable division. This is where cash flow comes in as analytic tool.

As an investor, it’s not good but it is acceptable that the second division is losing money.  But it’s a great comfort if the division is in the black on a cash flow basis, as WYNN is in Nevada.  Operating leverage can be a worry if there’s a significant chance it can turn negative.  But it can be a longer-term plus, if you think there’s a bigger chance operating leverage can eventually turn positive.

That’s it for today.  Tomorrow, cash flow per share and value investors.

cash flow

cash flow

Yesterday’s post probably contained more than you will ever need to know about depreciation.  Today’s topic is cash flow.  Tomorrow’s will be a discussion of whether cash flow or net profits is a better indicator to use in evaluating a stock.

four possible sources

What makes cash flow important is that it is a broader measure of a company’s ability to generate money from operations year after year than net profit is.  Professional investors normally consider four sources of funds in calculating cash flow. They are:

–net profit

–depreciation and amortization (which is essentially depreciation under another name)

–deferred taxes

–changes in working capital.

The four items should be found either in a company’s cash flow reconciliation statement or in the footnotes to the balance sheet.   In the US, all are contained in the “cash flows from operating activities” section of the cash flow statement.

I stick with two

Not everyone uses all four items.  There’s universal agreement (or as near as you can get in any human endeavor) that a cash flow calculation should include net profit + depreciation and amortization.  The question is whether to include the other two. And the issue is whether they provide a recurring source of cash.  My own opinion is, except in heavily government subsidized industries like mineral extraction where taxes always seem to be deferred, to exclude both deferred taxes and changed in working capital.

The worry about deferred taxes is that they arise from differences in the timing of when the tax expense is shown on the financial reports to shareholders and when the cash is ultimately paid to the tax authority.  So they often reverse themselves in relatively short order.

How can this happen?  One main reason is that governments often give companies a tax incentive to invest by allowing them to take rapid depreciation deductions.  In most countries (Japan is the only exception I can think of) financial reports use straight line depreciation, which slows and smooths the depreciation deduction.

An example:  For a $1000 item with a 5-year life and no salvage value, where government allows double declining balance depreciation, the yearly deprecation expense for taxes vs. for financial reporting looks like this:

tax     400     240     120     120     120

fin      200     200     200     200     200

Δ        200      40      (80)     (80)    (80).

Let’s assume (to keep things simple) that there are no other differences between the tax books and the financial reporting accounts.  If so, in year 1 the financial reporting accounts will deduct 200 from revenue for depreciation vs. 400 on the tax books.  Therefore, the report to shareholders will show pre-tax income that’s 200 higher than the tax books will show to the government.

What to do about the 200 in “phantom” income on the financial reporting books.  Not to worry, the financial reporting accountants will make a tax provision of 70 (assuming a 35% corporate tax rate) for the “extra” income.   They will label the 70 as deferred taxes and establish a balance sheet entry to hold the phantom tax payment.  They will also enter the 70 as a positive cash flow from operations on the consolidated cash flow statement, to show that the 70 hasn’t actually been paid to the tax authority.  (I’m not making this up.  This is what they do.  Don’t ask me why.)

In year 2, the procedure is similar to that of year 1, but the amount is 14.

In year 3, the depreciation deduction for financial reporting purposes is higher than that for the tax authority, so more actual taxes–an extra 28 per year–are paid.  Financial reporting accountants handle this by reversing their prior procedure–subtracting 28 in deferred taxes each year from the balance sheet, the tax entry on the income statement and the cash flow statement.

The details–bizarre as they are–aren’t so important.  The point to remember is that unless a company is continually investing, the deferred tax additions to cash flow will soon reverse themselves.  So they can’t be counted on as recurring sources of cash flow.

The other iffy item, in my view, is changes in working capital. There are negative working capital businesses.   Public utilities, restaurants, and hotels are examples.  Their customers pay for the companies’ products either in advance or very quickly after using them.  The companies, on the other hand, pay their suppliers only with a time lag, say, 30 days after delivery.  So such companies enjoy a “float” equal to perhaps 20 days worth of sales.  As long as sales are increasing, this “float” not only persists–it gets bigger!  The increase in payables minus receivables shows up on the cash flow statement as cash coming in from operations.  The amounts can be very large.

This isn’t exactly risk-free money, however. If sales begin to contract, so too will payables–meaning the company will have to return part of the float it has enjoyed from its suppliers.  And it better have the cash to be able to do so.  This is my reason for not counting working capital changes either.

(One other note about working capital, which I really consider a separate item for analysis.  There are firms whose market position is weak enough that their suppliers don’t give them much trade credit and they are also compelled to finance their customers’ purchases for long periods of time.  The worst I ever recall seeing was the Japanese sporting good company, Mizuno, which in the Eighties was giving its customers two years to pay.  In order for the company’s sales to grow, this trade financing–a use of corporate funds–had to grow as well.)

cash flow vs. free cash flow

Analysts often try to distinguish between (gross) cash flow as described above and (net or) free cash flow.  The latter is what’s left from profits + depreciation after all corporate calls on that cash have been satisfied.  These calls are generally:

–capital expenditure, i.e. reinvestment in maintaining and expanding plant and equipment

–working capital needs

–repayment of debt

–dividends to shareholders.

sounds good, but a somewhat nebulous concept

Although the concept of free cash flow is clear, arriving at a practical figure–especially when analyzing the company as an acquisition target–is a lot murkier than it might sound.  First of all, if you or I were acquiring a company, we probably wouldn’t pay dividends any more (we’d cancel our jet rentals and ride around on the corporate plane instead; we might have the company “invest” in a golf course in a resort area, too–and inspect it frequently).

We might think that the current owners’ capital spending plans were too aggressive or wasteful.  In either case, we could pare them back.  We might also think that the firm’s working capital management is very inefficient.  And we might feel we could refinance existing debt at a more favorable rate.

the unenviable case of utilities

However fuzzy the actual calculation may be,  we can probably best see what the distinction wants to highlight by considering a (highly simplified) public utility, like a local gas or electric distribution company.  Regulators in most countries grant such utilities a maximum allowable profit that’s calculated as a percentage of the utility’s net (meaning still undepreciated) plant and equipment.

Let’s say the allowable return is 5% and the net plant and equipment is 1000.  In the first year, the company is permitted to achieve a profit of 50.  During that year, the company records depreciation expense of 25.  Cash flow is therefore 75.

But starting out in year 2, absent any new building, the net plant is only 975.  Therefore the maximum allowable profit is 48.75–a fall of 2.5%.  In order to keep profits flat from year to year, the utility has to reinvest its depreciation to get the net plant back up to the prior year’s level.  To have, say, a 2.5% profit increase, the utility has to make its net plant grow by that amount–meaning it has to reinvest depreciation + another 25 (half its profit) back into the business.

This is the ultimate case of a company whose cash flow is not free.  Looking at the utility sections of stock services like Value Line, which calculate cash flow and price/cash flow ratios will show you what stunningly low multiples of cash flow pure utilities trade at.  The fact that most of the cash has to be plowed back into the business just to keep the ship afloat is the reason why.

That’s it for today.


I want to talk about subscription services and about cloud computing in particular.  This and the next couple of posts will lay some groundwork.


As as investor, I’m interested in depreciation in the accounting sense–the expense on the income statement that represents the allocation of part of the cost of a capital asset (that is, an asset that lasts a long time, like a factory or a piece of machinery) against revenues in a given period of time.  (In an economic sense, which I’m not going to write about here, depreciation is the wearing out or obsolescence of a capital asset.  The two senses of depreciation aren’t the same thing.  In the accounting sense, for example, the laws in a given country or accounting convention determine what can be written off, and by how much.  A factory building, for instance, amy be allowed to be written off over 40 years.  At the end of that time, the carrying value on the balance sheet will be zero, or very close.  But the structure itself may be economically usable for another 20 years.  A further aside–this difference can be very pronounced when dealing with the depletion of mineral reserves.)

a non-cash charge

Depreciation doesn’t represent an outlay of cash during the period it is charged against income.  The factory is already built and the machinery is already installed before anything is made for sale.  It actually represents an inflow of cash which the company is not considering to be profit, but rather recovery of a portion of the capital investment it has made in plant and equipment.

figuring what the quarterly depreciation expense is

To determine the depreciation expense in a given accounting period, a company needs several pieces of information.  They are:

–the cost of the capital item

–its estimated useful life

–estimated salvage value, and

–the method to be used in allocating the depreciable cost (cost – salvage value) over the useful life.

Two allied concepts to depreciation are amortization and depletion. Depletion is the cost allocation procedure for the value of mineral reserves;  amortization is the procedure for intangible assets.

depreciation methods

straight line

The most commonly used method of depreciation in financial reporting is straight line. This means that the depreciable cost is spread in equal amounts over the estimated useful life.  Let’s assume, for example, that an asset has a cost of 1,000, a useful life of 10 years and a salvage value of zero.  The the depreciable value is 1000 – 0 = 1000.  1000/10 years = 100/year.  This means depreciation expense of 25 per quarter or 100 per year.


Sometimes companies feel that assets, like computer systems, lose value faster than the straight-line method allows for.  So they will voluntarily use a depreciation method that writes off a larger amount of the asset’s cost in the earlier years of its life.  More often, governments will give companies a tax break by allowing them to use an accelerated depreciation method for writing off a given type of investment on the company’s tax return.

two accelerated techniques

There are two main methods of accelerating depreciation.  They may not make a lot of intuitive sense, but since they’re mostly intended as tax breaks, that shouldn’t matter too much.

1)  declining balance

Declining balance is the name for a family of depreciation schemes that key off the straight line depreciation method.  Specific declining balance schemes are designated as, say, 2x declining balance, 1.75x declining balance, etc.  The number in front refers to the multiple of straight line depreciation that’s applied each year to the depreciable balance for the asset.  “Declining balance” refers to the fact that the the gross depreciable amount declines.  It is reduced each year by the value of the prior year’s depreciation, before the new depreciation is calculated.

For example, let’s say we’re going to use double (2x) declining balance to depreciate the above ten-year life asset with original cost of 1000 and no salvage value.  For a ten-year life asset, straight line depreciation is 10% of the value each year.  Using 2x declining balance means using two times the straight line percentage, or 20%, as the percent of the asset value that we’ll depreciate in each year.

In year one, this means our depreciation is 20% of 1000, or 200.  For year two, we first subtract last year’s depreciation from asset value; that is, 1000 – 200 = 800.  Second year depreciation is 20% of 800, or 160.  In year three, the depreciable balance is 800 – 160 = 640.  Depreciation is 20% of 640, or 128.  And so on.

One quirk–the declining balance method can never get the asset fully depreciated, because you’re always taking only a fraction of the depreciable balance each year.   So accountants made up a fudge to get the system to work.  At some point, declining balance gets you a smaller depreciation expense than using straight line would.    In our case it’s at year six (where 2x declining balance = 20% of the depreciable balance; straight line = 25%).  At that point, you switch to using straight line for the remaining years.

3) sum of the years digits

This method, which doesn’t have any rationale that I can see, is nevertheless pretty straightforward.  Take the estimated useful life in years.  Add together all the digits from one through that number.  That gets you the denominator of a fraction.  Assign the highest digit of the series to the first year of depreciation, the next highest to year two, etc.  That get’s you the numerator.  For each year, multiplying  (the gross depreciable amount) x (the digit assigned) /(sum of the digits) = that year’s depreciation.

For example, in our ten-year lived asset, the sum of the digits 1-10 is 55.  Therefore, first year depreciation is 1000 x 10 /55 =   181.82.  Second year depreciation is 1000 x 9 /55 =  163.64.  And so on.

Two points:

–depreciation is a key element in the calculation of cash low, which is the topic of the next post in this series, and

–the difference in between the taxes on profits as shown in a given financial report to shareholders and the (often much lower) amount actually paid to the tax authority gives rise to deferred taxes, which can be a key element of cash flow as well.

More about these topics in the post on cash flow.