When evaluating core operating income for a business using their annual report, do you exclude the effects of depreciation and amortization? Specially, what about amortization of intangible assets? What does the astute value investor do?
Michael Wei: Not normally, because in most cases D&A represents a reasonable estimate of the “wearing out” of productive asset each year and it’s a real operating cost. If you believe in a particular case the D&A number isn’t a good representation of this productive asset “wearing out”, you must substitute it with average forward looking capex each year needed to *sustain the business at its current level*. Basically, almost all capital assets will wear out year by year and they must be replaced if the business is to be sustained. That cost is a part of operating expense.
Reaz H.: Thank you for that explanation. I see your reasoning very well. How about intangible assets though? Can you think of a case where an intangible asset amortization can be excluded? The reason I bring this up is because I was going through the 2016/2017 10K for QRVO last week and noticed a huge discrepancy between the operating income large amortization expenses. I normally do not adjust cashflows from operations or operating income (unless I capitalize off balance sheet operating leases). And so then I noticed that there were these large amortization values that were included as costs in the income statements and added back in cash flows. I do also know that QRVO made a huge merger/acquisition of TriQuint and RFMD a couple of years back. Just wondering how to best interpret this situation (in the context of value investing). Also no, I did not buy QRVO and missed out on the huge 20+% bump over the last 2 days.
Michael Wei: The way to look at intangible asset amortization is to look at its amortization schedule (# of years), and ask yourself: does the earning power derived from this particular intangible asset go away when it’s fully amortized? In many cases it would be …See more
Reaz H.: Thank you for this explanation. Definitely gives more more clarity and something to think about.
Michael Morse: Thank you for asking this question…i need to to boost my knowledge in this field of study.