In preparing a DCF valuation, you often use the current EBIT as a base to arrive at future cash flows. However, EBIT includes all income and expenses that the company has encountered. This includes items that are regular and recurring and those that are irregular and may not occur. When we are valuing a company, we only what to know what the cash flows are likely to be in the future. Only cash flows that we can expect to occur again from today onward provide us value. Therefore, the EBIT must reflect only items that you will expect in the future.
The portion of R&D spend that is capitalized is usually only a small part of R&D. However, most companies benefit from R&D spending in the form of acquired know-how. This acquired know-how is a valuable asset that produces cash flow in the future. Analysts and investors should want the value of R&D spending in the balance sheet. So R&D should be treated like another investment and the R&D spending capitalized like other assets such as an investment in a building. But how do you capitalize R&D expenses? What are the steps involved in capitalizing R&D expenses?
This article discusses the steps involved in capitalizing R&D expenses.
Background: Accounting regulation requires research and development expenses be considered an operating expense and written off in the income statement. There are specific exceptions to this rule. For example, when a product has become commercially feasible in the pharmaceutical industry, all associated costs can be capitalized and considered a capital asset. This capital asset can then be reflected in the balance sheet. The difficulty in accurately valuing the benefits of R&D and the duration of the associated benefits is a primary reason that R&D is not capitalized. But why is this a bad practice from a DCF valuation practice?
This article discusses why is expensing R&D expenses is a bad practice from a DCF valuation perspective.
Depreciation is the allocation of the cost of a tangible fixed asset over its useful life. Amortization is the allocation of the cost of an intangible asset over its useful life. In both cases, there is no cash flow associated with these assets after the year of purchase and so should not affect your cash flows in a DCF valuation. However, both depreciation and amortization become relevant in a DCF valuation under specific conditions. Only under specific conditions is there a difference between depreciation and amortization from a DCF valuation perspective.
This article discusses the specific conditions when there will be a difference between depreciation and amortization from a DCF valuation perspective.