Animal magic

Couple these factors with looser regulation and faster lead times to market in drugs for animals compared with those for humans and it is little wonder that the City loves the company. Using what Dechra labels its 'underlying' profits, at 980p, its shares are rated at 24 times earnings for the year just ended, falling to about 22 times for the period just begun.

Yet arguably the greater wonder is why City analysts and investors don't look more closely at Dechra's profits. If they did, they might conclude that an ambitious rating that reflects Dechra's good prospects is more like a fanciful rating that pays little attention to the realities of sensible accounting and cash generation.

Year after year - perhaps so consistently that analysts no longer give thought to the matter - Dechra focuses on the underlying profits it generates (see table). These are always substantially higher than the 'basic' profits. The reason for the difference is that underlying profit is arrived at before various charges are levied, while the basic figure is after their inclusion. Chief among these charges - £17.9m out of £18.4m in 2014-15 - is amortising (ie, writing off) the intangible assets that arose from past years' acquisitions; items such as product rights, licensing agreements or patents.

But it's debatable whether Dechra's underlying profit really is the key figure. That's because amortising acquired intangibles is a real cost to a company, so sidestepping it merely as an inconvenience is wrong.

First, consider why it's supposed to be okay to ignore amortising intangibles. It's not a cash cost; none of the £17.9m that Dechra charged in 2014-15 was cash out during that year. Therefore, runs the argument, it is silly to blur the picture with a non-cash charge. Second, there is a variation on this theme. To the extent that acquisitions are funded by issuing new shares, and because new shares clearly are not cash, then it is even foolish to include the amortisation of acquired intangibles in calculating true profits.

Both arguments fail. Let's start with the variation. Even if an acquisition is funded by issuing shares, then value passes from the acquiring company's shareholders to those of the acquired company. Rather than use cash, the acquirer is using the buying power that resides in its equity, but the effect is the same - value has been exchanged, an asset has been acquired and the capital transaction needs to find its way into the company's income statement. If the acquired assets are bought with cash, it's more obvious that amortising the acquired intangibles should be charged against profits, but, actually, it's no more true. Forever sidestepping amortisation costs would effectively mean that cash spent building a company never enters the income statement as a charge. That's a great way to flatter profits, but it's no way to assess a company's true profits.

In Dechra's case, in the 11 years 2005-15, the company's cash spending on acquisitions was £228m; in addition, it raised £101m via new shares, some of which probably funded acquisitions. Not much of this is costed in the underlying profits that both Dechra's bosses and City analysts highlight. Yet that distorts reality because Dechra's growth is driven by acquisitions. Over that same period the group's capital spending was barely £50m. No one would seriously argue there was no need to charge that item before arriving at underlying profits, so why should Dechra's far greater spending on acquired intangibles be ignored?

The solution may be to focus on Dechra's cash profits; after all, as they say, accounting profits are a number but cash is real. Do that and Dechra does not fare too well. The table hints at the volatility of cash flow. Yet for the much longer period 2005-15, Dechra's free cash flow per share - the amount left over for shareholders after deducting all recurring costs - smoothes out at just 19p a year on average. That hardly justifies a share price north of £9, although the trend may be improving. However, if - for the reasons just outlined - we include Dechra's cash spending on acquisitions as quasi capital spending and thus a recurring cost, then the picture is bleak. In aggregate over 2005-15 Dechra has lost money. Though - again - the trend seems to be improving.

Although our focus has been on Dechra, the problem is generic - too many companies take this approach. Dechra is just particularly easy to highlight because the numbers are especially big and its accounts are nice and clear. But the point is that amortising acquired intangible assets is a real cost for a company. To ignore it is to accept a distorted picture of profits, which leads to a distorted judgment.