We may sound like a broken record when talking about ROIC, free cash flow per share, and DCF analysis when valuing a stock. But they are important.

Making estimates for future free cash flow and ROIC requires understanding a company’s capital expenditures (capex). Specifically, investors need to understand the difference between growth capex and maintenance capex. 

This graphic explains the concept in more detail: 

Essentially, maintenance capex is laid out to maintain current operations. Growth capex is laid out to (hopefully) grow future revenue and profits. 

But why do they matter? Because it is important for estimating the future profits of a company while also normalizing current cash flow. Both will help you better evaluate whether a stock is a buy today. 

Growth capex and reinvestment runway

Growth capital expenditures are vital due to their connection to ROIC. 

For example, let’s say you are looking at a promising restaurant stock with plans for national expansion. It currently only has 50 locations but wants to grow to 1,000 locations over the next decade while maintaining its current ROIC figure. 

When looking at this restaurant, maintenance capex will be the money invested every year to maintain existing locations. Growth capex is money spent to open new locations.

Typically, a restaurant stock will tell you how much it costs to build a new location. For our example, we can assume a new restaurant will cost $5 million to build. Multiply this number by 950 new restaurants set to open and the company has the potential to spend $4.75 billion in cumulative growth capex in the future. This is what’s known as the reinvestment runway. 

To illustrate why this is important, let’s compare this theoretical restaurant today vs. its future earnings power. Assuming today the restaurant has $250 million in invested capital to maintain current restaurants (depreciation is offset by maintenance capex every year) with a 15% ROIC, it will generate $37.5 million in annual earnings (ROIC x $250 million).

If the company can reinvest in growth capex and grow this invested capital figure to $5 billion while maintaining its 15% ROIC, its annual earnings will jump to $750 million. 

Evaluating a reinvestment runway — or how much growth capex can be spent — is important in valuing a growth stock. 

Maintenance capex and normalized free cash flow

On the other side of the equation, we may want to separate our growth capex from our earnings calculation in order to normalize a company’s annual cash flow. 

Maintenance capex is the amount of annual capital expenditures a company would need to spend if it decided it didn’t want to grow. 

A shortcut method to estimating maintenance capex is adding up depreciation and amortization. This can be a somewhat useful answer, but it isn’t perfect. The more exact method is to calculate what growth capex was spent during the year and then subtract this from the company’s total capex.

For our restaurant example, we would take the number of restaurants opened in the year, multiply it by the cost of opening a restaurant, and subtract it from the total capex. 

Another method can be used (graphic with details below) that uses total property, plant, and equipment (PP&E, otherwise known as invested capital). You take PP&E, divide it by total sales, and average out the previous five years. This will get you an estimate of how many dollars it takes of PP&E to support a dollar of sales. 

To estimate growth capex, you then look at the nominal amount of sales added in the year and multiply it by this ratio. This will get you a growth capex figure, which you can subtract from the total capex to get your maintenance capex figure. 

Why is this important? Because a company laying out a ton of growth capex may look expensive but is actually highly attractive.

In our restaurant example, let’s say the company is generating just $10 million in free cash flow every year. If it trades at a market cap of $500 million, the stock has a P/FCF of 50, which looks expensive in a vacuum.

However, if the company opened up 10 stores that year, spending $50 million on growth capex, the normalized free cash flow using just maintenance capex would grow to $60 million. This would bring the normalized P/FCF down to 8, which could indicate the stock is dirt cheap. 

Free cash flow is what matters, but over the long-term. Not just one year.

Separating out a company’s growth vs. maintenance capex can help an investor identify a stock’s true earnings power over the long-term and whether it is undervalued today.