Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Amortize====== Amortization is an accounting technique used to periodically lower the book value of a loan or an [[Intangible Asset]] over a set period. Think of it as slicing up a large, upfront cost and spreading the slices out evenly over time. For a loan, like your mortgage, it means paying it down with regular installments of [[Principal]] and [[Interest]]. For a business, it's the process of expensing an intangible asset—like a patent or a trademark—over its useful life. This practice helps to tie the cost of the asset to the revenue it helps generate year after year. For a value investor, understanding amortization is crucial because it affects a company's reported profits, but it isn't an actual cash expense. This distinction is key to uncovering a company's true earning power. ===== How Amortization Works ===== The concept works in two main arenas: personal loans and corporate accounting. While the math is similar, the implications are quite different. ==== In Your Personal Life: Loans ==== This is the amortization you're most likely familiar with. When you take out a loan for a house or a car, you pay it back in fixed installments over a set term. Each payment is a mix of two things: * Interest: The fee you pay the lender for borrowing the money. * Principal: The actual amount of money you borrowed. At the beginning of the loan, most of your payment goes toward interest. As time goes on and you chip away at the balance, a larger portion of your payment goes toward paying down the principal. An //amortization schedule// is a table that details exactly how each payment is split between interest and principal over the entire life of the loan. This front-loading of interest is why paying extra on your mortgage, especially in the early years, can dramatically reduce the total interest you pay and shorten the loan term. ==== In Business: Spreading the Cost ==== For businesses, amortization is the cousin of [[Depreciation]]. While depreciation is used to expense tangible assets (like buildings and machinery), amortization is used for intangible assets. These are assets you can't physically touch but which have significant value. Examples include: * Patents * Copyrights * Trademarks * Customer lists * Brand recognition The idea comes from the [[Matching Principle]] in accounting, which states that expenses should be recorded in the same period as the revenues they help to generate. If a software company pays $5 million for a patent that will be valuable for 10 years, it doesn't make sense to record a massive $5 million expense in Year 1 and zero for the next nine. Instead, the company records an amortization expense of $500,000 ($5 million / 10 years) on its [[Income Statement]] each year. This provides a more accurate picture of the company's profitability over time. ===== Why Value Investors Care About Amortization ===== On the surface, amortization seems like a dull accounting rule. But for savvy investors, it's a breadcrumb trail leading to a deeper understanding of a company's financial health. ==== A Non-Cash Charge ==== This is the most important point to remember. The amortization expense you see on an income statement is a [[Non-Cash Charge]]. The company isn't writing a check for "$500,000 - Annual Amortization" each year. The real cash went out the door when the asset was first purchased. Because amortization reduces a company's reported [[Net Income]] (or "profit") without being a real cash outlay, it can make a company's earnings look weaker than its actual [[Cash Flow]] generating ability. This is why legendary investors like [[Warren Buffett]] pay close attention to it. ==== Adjusting Earnings for a Clearer Picture ==== Value investors often adjust reported earnings to get a better sense of a company's true economic reality. A common first step is to add back non-cash charges like depreciation and amortization to net income. This is the "DA" in [[EBITDA]] (Earnings Before Interest, Taxes, Depreciation, and Amortization). This adjusted figure gives you a better proxy for the cash the business is generating. However, a word of caution: you can't ignore these costs completely. While the patent from our earlier example doesn't require a cash payment each year, it will eventually expire. The company will need to spend real cash on research and development to create a new one. Buffett's concept of [[Owner Earnings]] takes this into account by subtracting the estimated average annual capital expenditures needed to maintain the business's competitive position. ==== Goodwill: A Special Case ==== [[Goodwill]] is a unique intangible asset created when one company buys another for a price higher than the fair value of its identifiable assets. It represents things like a strong brand, good customer relations, or a brilliant management team. Under current accounting rules ([[GAAP]] in the U.S. and [[IFRS]] internationally), Goodwill is no longer amortized on a fixed schedule. Instead, companies must test it for [[Impairment]] at least once a year. If the value of the acquired company has fallen, the purchasing company must take an impairment charge, which is a one-time, often massive, write-down of the goodwill. For an investor, a large impairment charge is a major red flag, signaling that management likely overpaid for a past acquisition. ===== The Bottom Line ===== Amortization is more than just accounting jargon. It's a window into how a company invests in its future and how its financial performance is reported. * For //you//, it's the process of paying down a debt. * For a //company//, it's the process of expensing a valuable intangible asset over time. By understanding that amortization is a non-cash charge, you can look beyond the headline profit number, better assess a company's cash-generating power, and spot potential red flags like a big goodwill impairment. It's a simple concept that, once grasped, gives you a much sharper lens for analyzing businesses.