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
Distinguishing between each type of capex can provide an investor with insight into both the growth potential and capital intensity of a company.
The reality of business is that some assets require heavier upkeep (maintenance expenses) than others, even though those assets might produce similar cash flows. A business with assets like this will need to reinvest its profits just to remain in business; this leads to less available cash flow which can be distributed back to shareholders.
If you ever wondered why utilities have so often underperformed the market even during some of the most turbulent bear markets, it’s because many of them have to use their capital on expensive maintenance capex just to provide valuable services to their customers. What little is left is usually distributed to shareholders in a dividend, leaving little to none cash flows left to reinvest into growing the business. Thus, the mediocre results.
Companies depend on growth capex as fuel in order to maintain steady increases to their top and bottom line, and so just like no two assets are truly equal, neither are two different capital expenditures.
- Growth capex: used to acquire assets which are expected to produce higher revenues, profits, and free cash than the assets which are currently owned by the business
- Maintenance capex: used to either repair, maintain, or replace the assets which currently produce the company’s revenues, earnings, and free cash for the business
Assets deteriorate over time, which is why they are depreciated over a useful life in a company’s financials.
Easy Example of Growth Capex: Taxi Company
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 akin to 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 replaces 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 which was not available previously.
How Growth Capex Can Affect Valuation
Because of this dichotomy between growth and maintenance capex, investors can do themselves a disservice if they never adjust for these differences.
One of the simple calculations for free cash flow, which is used for a DCF valuation, is Cash from Operations minus Capital Expenditures.
Note: capital expenditures is also called “Additions to Property, Plant, and Equipment”, where PPE is the long term assets which create the expected future cash flows we’ve been discussing.
In company financial statements, there’s no requirement from the SEC to distinguish maintenance and growth capex as two separate line items. So, both get lumped in together and treated the same, even though we know they are two very different things.
This makes a company’s growth potential and earning power look worse than it really is, if the company happens to be reinvesting heavily into significant long term assets.
Capital Allocation: Acquisitions vs Growth Capex
It’s a somewhat curious thing because acquisitions are generally not calculated with free cash flow, but rather calculated as an allocation of free cash flow. Growth capex, while arguably trying to achieve the same thing, is generally lumped into free cash flow and is a part of FCF instead of an allocation of it, which reduces the FCF estimation unless investors adjust it out manually.
You’ll see many websites that publish free cash flow per share and P/FCF metrics for companies, but don’t make the distinction between maintenance and growth capex.
This can make an investor miss out on many great growth companies which are actually trading at good value, if the investor looks only at free cash flow estimates without considering how much FCF might be suppressed today in order to reinvest in a multiplied return and great future growth tomorrow.
Warren Buffett’s Thoughts on Growth Capex
Even one of the more conservative great investors of our time, Warren Buffett, recommends separating capital expenditures into these two growth and maintenance buckets.
His definition of owner’s earnings, which is what he uses instead of free cash flow, 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.
Everything before subtracting maintenance capex is the way Buffett estimates the true cash flow generated by a business. The maintenance capex simply includes the recurring investments a business must make to continue its current levels of profitability.
In effect, Buffett is adding back a growth capex into his owner earnings formula, which would make his estimates of free cash flow higher than the standard estimate you’ll likely see on an investing website—if that company is heavily investing in its future through capex.
This means that it is possible to be a conservative investor buying stocks with a margin of safety even if on the surface the stock doesn’t look cheap on traditional metrics.
That said, you have to be really sure that you’re estimating growth capex correctly, which we’ll focus on next.
There’s also a blatant way to misinterpret the application of growth capex which can wildly overestimate a company’s value, and essentially “double count” the effect of growth capex. We’ll cover that later in the post too.
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.
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 showed 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 because it is assumed 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 less opportunities to reinvest for high growth and/or the company won’t find it efficient to invest in growth, and 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 of undervalued stocks as long as the industry can support continued growth and/or the valuation allows for that growth to taper off and be distributed to shareholders instead.
Valuation is very much more an art than it is a science, and that becomes increasingly apparent when you consider the variability from a critical input such as FCF as it relates to company reinvestment (and growth capex).
Personally, I always try to err on the side of caution and not even muck with the capital expenditures figure especially when looking at more matured companies and industries.
However, there is a time and a place to do so, and this can be more apparent in companies with higher growth rates, favorable tailwinds, and high potential.
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, in order to help investors buy growth stocks at a reasonable price, which can greatly reduce future drawdowns and increase overall long term returns.