Capital Expenditures Explained

Capital investment, also referred to as capital expenditures or CapEx for short, is the spending necessary for a company to maintain and grow its operations. As an investor, responsible CapEx is extra important for shareholders to keep an eye on in order to analyze if the company is earning an appropriate return on invested capital which leaves enough room to return cash to shareholders.

This article will help investors understand what forms capital investment can take, where to find capital investments in the financial statements, and which capital investments to include in a net present value calculation.

What is included in CapEx?

CapEx is associated with long-term assets and as such is also commonly referred to as capital investment because the spending is an investment expected to earn a return over a long period of time.

Items which would fall into CapEx include long-term assets shown on the balance sheet under the common category property, plant, and equipment (PP&E) which can include items such as land, buildings, machinery, furniture & fixtures, computer equipment, automobiles, and even software development.

These days, accounting policies for technology companies have caught up to reality and even long-term spending on key software production can be capitalized under both IFRS (IAS 38) and U.S. GAAP (ASC 350) if the product is expected to last beyond any given year.

As CapEx is spending on assets that are long-term in nature, the amount being spent is first capitalized on to the balanced sheet and then expensed off of the balance sheet according to the useful life of the asset. If the asset in question will be used up within the year, this is not CapEx and the cash spending is instead immediately expensed within the year.

Below are what the journal entries will look like for CapEx being made and then subsequently depreciated in later years.  

Journal entry on initial spending:

Debit: Property, Plant, and Equipment

            Credit: Cash

Subsequent journal entry for Depreciation as time passes:

Debit: Depreciation Expense

            Credit: Property, Plant, and equipment

Where to find CapEx in the Financial Statements?

As CapEx is not depreciated within one year, the amount of PP&E on the balance sheet is a cumulative net total of the historical CapEx yet to be depreciated. Likewise, the depreciation expense running through the income statement is not associated with the CapEx spending of any given year, but, is a combination of the depreciation needed after many years of CapEx on various asses.

So where can investors find this important CapEx number?

The answer is of course the cash flow statement. As can be seen below with Coke, CapEx for any given year is shown within the cash flow statement under investing activities.

CapEx needs to Subtracted out of Cash Flows in an NPV

If depreciation is the friendly non-cash expense added into cash flow from operations, CapEx is its ugly reincarnation running through cash flow from investing activities. When discounting cash flows for any net present value (NPV) calculation, CapEx needs to be included as a cash outflow.

Even if the business is in a mature and steady-state, capital investments will need to be made as assets slowly deteriorate. This deterioration is also called obsolesce and will happen to all assets (except goodwill!) such as buildings, machinery, furniture, computer equipment, and even intangible assets such as software or patents. Worst off is that due to inflation, CapEx will most likely be higher than the depreciation expense of older assets which were purchased in prior years when the assets in question were less expensive.

This regular type of capital investment is referred to as “sustainable” CapEx. To get a visual analytical example, let’s look at Coke below where the average level of capital expenditures over the past 10 years were 20% higher than depreciation. This level above depreciation shows not only inflation but likely some growth CapEx spending as well. Also, the low standard deviation around the average of 20% shows the consistency of CapEx spending on PP&E in the core budget.

Source data from Morningstar

Side Note: Analysts should include dispositions, in order to properly capture salvage value benefits of old assets within the larger CapEx amount being spent.

Acquisition Spending can be Equivalent to CapEx

As a critical value investor, we also need to remember to adjust cash flow projections for business acquisitions, especially if they are reoccurring and a regular part of the business model. Investors failing to factor in acquisitions to such an acquisitive business has led to many stock bubbles such as Valeant Pharmaceuticals.

Even for mature companies such as Coke, acquisitions can still make up a material part of regular spending in the capital budget as the company fights to maintain their moat by buying up new competitors.

Sourced from Coca-Cola’s 2018 Annual Report

As can be seen below in an analysis of Coke’s cash spending on acquisition over the past decade, they make up a much less significant part of the capital budget being on average 53% less than depreciation. They also are much more sporadic with a standard deviation of 126%. While hard to forecast, such average acquisitions should be conservatively included in any valuation of Coke as they represent a part of the company playing economic moat “defense”.

Source data from Morningstar

What about Purchases and Disposals of Investments?

Spending (and disposals) of investments are accounted for separately because they are more short-term in nature. Such short-term investment spending likely does not need to be included in the cash flows for an NPV because as they are not investments in the core business but are places to store excess cash.

Instead, the net total of short-term investments are added into the NPV as a positive excess cash portion through the cash & “equivalent” item on the balance sheet. Below is what these short-term investments and marketable securities look like on the cash flow statement and balance sheet for Coke. First up, the cash flow statement.

Sourced from Coca-Cola’s 2018 Annual Report

And here they are on the balance sheet.

Sourced from Coca-Cola’s 2018 Annual Report  

Growth above Inflation means CapEx will Need to be Higher

Sustainable CapEx is one thing, but to achieve growth rates that are higher than inflation will likely result in even higher CapEx spending to further grow the business. Up to a limit, investing capital into new assets should earn higher revenues and profits. That new capital being invested could come from retained earnings or new capital being sold, but, in either case that capital is expected to earn a return. Even technology companies need to have higher CapEx spending than depreciation in order to develop new and improved products which can grow the business.

CapEx vs. Share Buybacks

Great companies are able to achieve high returns on invested capital which can be hard to replicate when buying or developing new assets. For a company with a large economic moat in a saturated or mature market, the smartest thing for management to do might be to buyback shares if, when compared to new capital investment projects, their company’s shares are trading at a worthwhile return on equity.

“Diworsification” was a term coined by legendary investor Peter Lynch related to over-diversifying one’s investment portfolio into too many stocks which results in lowering the risk/return characteristics of the portfolio. The term “diworsification” can also be applied to a business’s asset portfolio when the company over-extends themselves through new growth projects and acquisitions which have lower return characteristics than the company’s existing business. The company might have been better off investing in their own shares.

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