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Type of Securities Investment Strategies Fundamental Analysis Technical Analysis
Introduction to Fundamental Analysis Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions

Income Statement Analysis

 - Great companies and good
    EPS growth do not guarantee
    stock market profits

 - The P/E ratio can create
    buying opportunities

 - Mishaps can create steals

 - Unusual charges reduce the
    value of your stock

 - ROE is the single best tool
    for investors

 - ROA is another valuable tool

 - Investors pay for high profit

 - Lenders can eat up all the

 - Depreciation creates
    deferred taxes, which have
    equity-like qualities

 - EPS is a complicated



Depreciation creates deferred taxes, which have equity-like qualities

Depreciation is the systematic allocation of the cost of property, plant and equipment over their useful lives. (Land is not subject to depreciation.)

As background, there are various depreciation methods used; each with the intent to properly match depreciation expense on the P&L, to the usage and decline in value of the underlying assets. Some of the methods used are the straight-line method, and accelerated depreciation methods, such as double declining balance and sum-of-the-years-digits.

While deprecation is a non-cash expense, fixed assets need to be repaired and maintained, and retiring assets need to be replaced. This costs money and therefore is a negative cash flow.

Replacement of, and additions to fixed assets, as well as repairs that extend their useful lives, are cash expenditures that are capitalized on the balance sheet. These expenditures are not reported in the P&L.  

To appreciate the complete cash picture, depreciation expense should always be analyzed in conjunction with capital expenditures.

Moving forward:

For tax returns, the IRS allows even faster depreciation methods, to give businesses incentives to purchase equipment that will stimulate the economy. The tax differential between GAAP depreciation and the faster tax deprecation methods results in deferred tax liabilities that are reported on the balance sheet. Depreciation is usually one of the main timing differences that generate deferred taxes.

Deferred taxes on the balance sheet result from the tax effect of the timing differences between book income and the tax return income. All events being held constant, deferred taxes become payable as the underlying transactions close out. That said, if a company is in a growth mode, and new deferred taxes get added annually and grow in amount, then deferred taxes never get closed out; they are essentially liabilities, with equity attributes. This tax relief reduces a company’s debt or equity needs. There is more money to grow the business.  Some companies, moreover, pass on these benefits to their customers.

Investors can benefit from those asset intensive companies that generate deferred taxes. General Electric (GE) is a good example of a company that benefits from deferred taxes. As of 9/30/06 they had shareholders’ equity of $111 billion, and deferred taxes of $16 billion. If not for deferred taxes, they would have had to issue more debt or equity. Their use of deferred taxes increases their ROE, and therefore their shareholder returns.

In general, deferred taxes are usually attributed to depreciation, and can also be viewed as free government financing. Free equity ultimately increases the overall value of a company.




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