Is depreciation or depletion really free cash flow

June 7, 2010

It has been observed by me, and possibly other people, that free cash flow, more than earnings, is a correct measure of an equity investor’s true returns (free cash flow is earnings plus depreciation minus capital expenditures). The logic behind this goes back to Benjamin Graham’s notion of calculating true earnings; he said that before a corporation should be deemed to have earned money, it has to maintain its own earnings power. Depreciation is a convenient proxy for loss of earnings power, but the linear decline of depreciation does not take into account the definitely nonlinear rate that most  capital assets wear out and there is definitely some degree of kurtosis in the data, as large capital expenditures tend to be made all at once. Of course, the free cash flow approach does not deal with the real problem of sudden obsolescence, but neither does the linear depreciation model.

It therefore follows that if the cost of maintaining the old earnings power of the capital has gone up, owing to, perhaps, more stringent environmental regulation, an increase in the cost of materials in making the machines, etc., then the old depreciation figures do not fully reflect the cost of replacing the capital in order to replicate earnings power. Likewise, if technological progress has made the capital assets cheaper, as often happens, then depreciation comes to be overstated.

However, there is a difference between capital expenditures intended to maintain earnings power and those intended to expand the business. This is the difficulty in valuing the domestically-focused Chinese firms that have interested me in the past, as has been observed by American Lorain‘s own CFO, who cited as an excuse for his firm’s negative free cash flow, “this past year we have been building out the factory lines for the expansion into the convenience food segment.” Unfortunately, few firms are willing to provide information sufficient to divide maintenance capital from expansion capital, which is baffling since American Lorain itself can state the problem in a single sentence.

So, when we have a company like Qwest that has maintained its earnings at roughly the current level for the last few years despite the fact that depreciation has exceeded capital expenditures, we may conclude that the firm, owing to lower replacement costs, historical overinvestment, or a changing strategic focus, does not need to replace the full amount of its depreciated capital in order to maintain earnings power, and thus its free cash flow is really free.

But, does free cash flow apply only to depreciation and amortization? What about other noncash expenses, like the depletion of mines and oilfields? After due consideration, I have had to conclude that depletion is not free cash flow. The point of free cash flow is that it is distributable, but depletion is meant to indiate the loss of reserves from a given property. Even if the firm earns an excellent profits on its resource extraction, if it distributes the depletion allowance as well it will have nothing to acquire new properties when the old ones are exhausted.

Therefore, in assessing whether a firm’s distributable income is actually free cash flow, watch out for excess depreciation coupled with loss of earnings power, or distributed depletion allowances in any event.

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