When a company invests in a long-term asset for future cash flows, these are called capital expenditures, or capex. Capex can be divided into two buckets: growth capex and maintenance capex, as suggested by Warren Buffett.
Capital Expenditures = Growth Capex + Maintenance Capex
These definitions can help distinguish between companies with high growth potential or capital intensity.
In this post, we will discuss the following:
- Easy Example of Growth Capex
- Two Ways to Calculate Growth Capex for a Company
- Don’t Make This Costly Mistake with Growth Capex
- Investor Takeaway
Companies depend on growth capex as fuel in order to maintain steady increases to their top and bottom lines. Just like no two assets are truly equal, neither are two different capital expenditures.
- Growth capex: used to acquire assets that are expected to produce higher cash flows in the future
- Maintenance capex: used to either repair, maintain, or replace the assets which produce cash flows today
Assets deteriorate over time, which is why they are depreciated over a useful life in a company’s financials.
Some assets require heavier upkeep (maintenance expenses) than others. This can be true even though those assets might produce similar cash flows. A business with high-maintenance assets will need to reinvest its profits just to remain in business. This leads to less available cash flow that can be distributed back to shareholders.
If you have ever wondered why utility companies have so often underperformed, it’s because many have high maintenance capex every year. What little cash flow is left is usually distributed via dividends, leaving little to none for reinvesting in growth. Thus, the mediocre returns.
Easy Example of Growth Capex
For an example of this, think of a long-term asset many people own – their car.
In order for your car to run smoothly over a long period of time, it must be maintained. These expenses don’t improve the performance of the car but rather keep it running.
At the same time, even with regular maintenance, the car will eventually die as its components and part wear out. So its value decreases (depreciates) over time, and the asset has a generally expected useful life.
If we were a taxi company, we might think of the purchase of a vehicle as growth capex. Changing the oil might be an expense charged to the P&L, while something more costly, like an engine overhaul, might be spread out over multiple years. We can think of the engine overhaul as maintenance capex, as it doesn’t generate additional earnings capacity but keeps the vehicle running along our expected useful life.
But if we were to add a row of seats to the back of a vehicle, as an example, this might add earnings capacity and could be considered growth capex.
Another example of growth capex, in this case, would be the purchase of multiple vehicles. Say one of our vehicles was crossing over its useful life and going to the dump. Say we purchased 3 additional vehicles in that same year as capital expenditures. In that case, 2 of the vehicle purchases would be considered growth capex, while one gets recorded as maintenance capex.
One of the vehicles simply replaced the old earnings power of the vehicle, which was getting phased out, and the two others gave us a fresh stream of growth and profits that was not available previously.
Warren Buffett’s Thoughts on Growth Capex
Even the conservative investor Warren Buffett recommends separating capital expenditures into these two growth and maintenance buckets.
His definition of owner’s earnings includes maintenance capex, with the equation explained as:
Owner’s earnings = Net Income + depreciation, depletion, and amortization and other non-cash charges – “maintenance” capital expenditures
This is the way Buffett estimates the true cash flow generated by a business. Maintenance capex simply includes recurring expenses for maintaining current levels of profitability.
In effect, Buffett is adding back a growth capex into his owner earnings formula. This would make his estimates of free cash flow higher than the standard estimate you’ll likely see on an investing website. That is, if that company is heavily investing in its future through capex.
Two Ways to Calculate Growth Capex for a Company
The first way is very easy. Sometimes management discloses exactly how they spend capex, and will even outline it in their 10-k as growth or maintenance.
Take $UFPI as an example (and their latest 10-k). The company stated:
“Our capital expenditures primarily consist of “maintenance” capital expenditures totaling approximately $55 million, as well as “expansionary and efficiency” capital expenditures. Notable areas of capital spending include projects to expand capacity and enhance the productivity of our Deckorators product line, several projects to expand manufacturing capacity to serve industrial customers and achieve efficiencies through automation, improvements to a number of facilities, and an increase of our transportation capacity (tractors, trailers) in order to meet higher volumes and replace old rolling stock.“
Right off the bat, we know that their maintenance capex is $55 million. From other parts of their 10-k (and the Purchases of property, plant, and equipment line item in the cash flow statement) we know that total capital expenditures for the year was $89.182 million.
Growth capex is simply total capex minus maintenance capex, so we can calculate it as:
=89.182 – 55 = $34.182 million
Unfortunately, most companies don’t explicitly break out their capital expenditures between growth and maintenance categories.
But that doesn’t mean we can’t estimate it.
The second way to calculate growth capex for a company is by looking at the company’s changes in PPE, revenues, and capex from year to year.
Growth Capex Estimate (Bruce Greenwald’s Formula)
Columbia Business School professor Bruce Greenwald outlined a simple method for estimating growth and maintenance capex as the following:
“We calculate the ratio of PPE to sales for each of the five prior years and find the average. We use this to indicate the dollars of PPE it takes to support each dollar of sales. We then multiply this ratio by the growth (or decrease) in sales dollars the company has achieved in the current year. The result of that calculation is growth capex. We then subtract it from total capex to arrive at maintenance capex.”
We have another super in-depth post on the site where Dave shows how to calculate maintenance capex (in a very easy way), which I recommend checking out as well.
Once you estimate either growth or maintenance capex, you simply subtract one from a company’s disclosed capital expenditures in order to calculate the other.
Don’t Make This Costly Mistake with Growth Capex
Hopefully, by now, we understand why calculating growth capex can be useful for finding companies with great potential and temporarily suppressed free cash flows.
But, we need to be careful when applying this concept to valuation, especially a DCF valuation.
What you can’t do is project high growth rates in addition to a higher free cash flow estimate.
The whole reason that growth capex is useful to investors is that it assumes that one day, the company won’t need to invest heavily into future growth and can allocate that capital back to shareholders (share buybacks or dividends) in order to boost total return.
What is implied here is that previous growth will slow down, and there will either be fewer opportunities to reinvest for high growth and/or the company won’t find it efficient to invest in growth, so that money that used to go to growth capex can be distributed.
When that happens though, the growth of future free cash flows will be constrained.
Therefore, it’s not logical to take a company’s past growth and project it into the future with a free cash flow estimate which adds back growth capex.
You can’t have the growth without the growth capex.
That means that if you’re adjusting your free cash flow estimates to account for the difference between maintenance and growth capex, you need to decide to project future free cash flows with the growth capex (and growth rate) continued as before (suppressing current FCF), or as growth slowed into the future but with a higher starting FCF figure for the DCF.
By doing this, you can make sure you’re not double-counting the effects of growth capex on the future of the business.
The corollary to this is if the company buys back stock to grow FCF per share.
In that case, you can model the extra growth capex capital as a driver to future growth, but with the understanding that there’s a chance that this proves to be an inefficient use of capital (especially the more expensive a stock gets), and probably doesn’t earn a similar high rate of return as the growth capex was able to (or else management would simply continue doing that).
You can also model a total return expectation from the extra growth capex capital by assuming a hefty dividend, which doesn’t directly grow FCF/share but does improve shareholder total return. This should help the valuation of a company as well, as total return is the end goal of most valuations done by retail investors anyways.
Finding companies with a high percentage of growth capex can be a great source for undervalued stocks. Investors would be wise to ensure that the growth potential is still there, and that the company has a strong moat.
Investing doesn’t have to be defined as “growth” or “value”; you can have both. And you can (and should) value a company higher for earning exceptional growth.
Calculating growth capex is a fantastic way to do that and buy growth stocks at a reasonable price. This can greatly reduce future drawdowns and increase overall long-term returns.