Blindly following conventions is the enemy of reality. When companies or investment professionals add back certain expenses such as stock-based compensation they want you to accept concepts that are dangerously defective.
In financial accounting, "amortization" is a widely used term - and one that could be misleading. First, a definition: Amortization is an expense on the income statement and it reduces the appropriate intangible asset on the balance sheet. If properly calculated, the amortization expense states the amount of the deterioration of non-physical assets such as customer relationships, trademarks, patents, and various forms of company agreements.
Management usually detests amortization expense because it usually saddles earnings with an annual charge that normally lasts for years. These charges are added back when management reports earnings. In addition, the investors also typically add back amortization expenses when calculating earnings. In a great many instances, this is correct because the value of intangible assets has not deteriorated. At a car insurance company, for example, the value of customer relationships is usually intact because buying insurance every year is required by law. In many cases, it actually grows if the customer buys more adjacent products such as home insurance.
Even though adding back amortization expense is a convention, it is not correct in all instances. Consider a pharma company that buys other branded drugs. These acquisitions would result in the creation of intangible assets on the balance sheet which will be amortized every year over its useful life. Nonetheless, management and investment professionals would add back this amortization expense while reporting earnings. This is deeply worrying. Management wants investors to assume that it can find similar acquisitions on a regular basis which is a tough assumption if you are a conservative investor.
In the banking industry, amortization of core deposits could be a real charge if those deposits are not stable as evidenced in the recent banking crisis. In the consumer staples industry, the acquired branded food could lose its market share to another competitor. Thus, the amortization charge shouldn't be added back. The foregoing examples illustrate that analysts should be very careful when adding back amortization expenses to determine the intrinsic value of the business.
Clearly, the attitude of following conventions that many management and investors have today is deeply troublesome. I urge investors to follow a reality-based approach to amortization expense.
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