one approximation of cash flow in practical use is eps plus depreciation amortizatio 570373

Accounting Methods and Cash Flow.

One approximation of cash flow in practical use is EPS plus depreciation, amortization, and depletion. Even this simple approximation can point to issues of interest to the analyst in valuation, as this stylized illustration shows. Hypothetical companies A and B have constant cash revenues and cash expenses (as well as a constant number of shares outstanding) in 2000, 2001, and 2002. Company A incurs total depreciation of $15.00 per share during the three year period, which it spreads out evenly (straight line depreciation, SLD). Because revenues, expenses, and depreciation are constant over the period, EPS for Business A is also constant, say at $10, as given in Column 1 in Table 4 14. Business B is identical to Business A except that it uses accelerated depreciation: Depreciation is 150 percent of SLD in 2000, declining to 50 percent of SLD in 2002, as given in Column 5. (We assume both A and B use the same depreciation method for tax purposes.)

Because of different choices in how Company A and B depreciate for financial reporting purposes, Company A’s EPS is flat at $10.00 (Column 1) whereas Company B’s shows 29 percent compound growth, ($12.50/$7.50)1/2 1.00 = 0.29 (Column 4). Company B shows apparent positive earnings momentum. As analysts comparing Companies A and B, we might be misled using EPS numbers as reported (without putting EPS on a comparable basis). For both companies, however, cash flow per share is level at $15. Depreciation may be the simplest noncash charge to understand; write offs and other noncash charges may offer more latitude for the management of earnings. Hawkins (1998) summarizes many corporate accounting issues for analysts, including how accounting choices can create the effect of earnings momentum.