Any company can instantly boost earnings by playing around with depreciation assumptions. Remember the taxi company we talked about in Part 1 of this article? If that taxi company wanted to book lower depreciation expenses, it could assume that its cars will last for 30 years instead of 10, thus spreading the "wear and tear" costs over a longer period of time. It could also assume that the salvage value of a car is $10,000 instead of $5,000, thus lowering the depreciable basis and the depreciation expense.
So what should investors do to make sure they can still evaluate the real performance of the company over time? The best way is simply to get familiar with a company's business and understand what would constitute a reasonable depreciation schedule. For example, if you know anything about cars, you'd know it's ludicrous for a taxi company to assume that a car will last for 30 years. Furthermore, because depreciation expenses are based on estimates, any company that plays games will eventually have to pay the piper. For example, just because a taxi company estimates that it can sell its cars for $10,000 apiece after 10 years, that doesn't make it so. As they say on Wall Street, you find out who's swimming naked when the tide goes out.
A quick way to find red flags
To find out whether a company is messing around with its depreciation assumptions, make sure you read the footnotes and calculate a few numbers. Let's take a look at a couple of quick examples.
Usually, it's a good idea to compare the depreciation rate of two companies in the same industry, since their assets would tend to depreciate at similar rates. Let's use Pacific Sunwear (Nasdaq: PSUN ) and teen-apparel competitors Abercrombie & Fitch (NYSE: ANF ) and American Eagle Outfitters (Nasdaq: AEOS ) . In general, we can use a couple of different metrics; depreciation/sales and depreciation/gross plant property and equipment are two that I tend to look at. For the first metric -- depreciation as a percentage of sales, which measures the margin impact of depreciation -- PacSun, A&F, and American Eagle had ratios of 4.5%, 4.3%, and 3.2%. For the second ratio -- depreciation as a percentage of gross PP&E, which measures how rapidly the company is depreciating its assets -- the ratios were 10.5%, 9.7%, and 11.1%. There's not much variation there, so at a glance, we can feel comfortable with these companies' depreciation schedules.
The more familiar you get with a company's assets and how long these assets last, the better you'll be at spotting when a company's playing games. Even better, you may be able to spot when a company is booking excessive depreciation, which means it's understating income and may have hidden value.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.