Depreciation is an expense that matches the cost of a fixed asset against the revenues it helps to produce. The cost of an asset is spread over its useful life.
The most common method of depreciating an asset is known as straight-line depreciation, where an equal amount is charged against revenue over the asset's useful life and is calculated as follows:
straight line depreciation = (cost - residual value) / estimated useful life
Depreciation is often seen as a proxy for maintenance or stay in business capex.
The problem with depreciation is that the management of a company can make it whatever value they want. The easiest way to do this is to say that assets will last longer than they will in reality.
Example
If an asset costs $10 million and will last for 10 years and be worth nothing after that time, the depreciation expensed against revenues for the next 10 years will be, $1 million per year.
($10 m - $ 0)/10 years = $1 million per year
In order to maintain the value of assets at $10 million, the company will have to spend $1 million on new assets each year (the amount it has depreciated by).
This is why depreciation is often seen as a proxy for maintenance or stay in business capex.
What if the $10 million asset only really lasts 5 years?
Depreciation should be $2 million per year instead of $1 million and profits should be $ 1 million lower.
If a company depreciates an asset by $1 million a year but actually spends $2 million to keep the asset up to date, then capex will be twice as much as depreciation but profits will be overstated by $1 million.
This will be picked up in the FCFps number but not the EPS.
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