Companies make money by selling stuff they make. To make stuff, they need to invest capital.
This invested capital (IC) often takes the form of PPE for traditional widget manufacturers. From a business standpoint, one can take a broader view of IC, and recategorize any expenditure that is borne in a particular period, but “pays off” over longer time periods as capital. Thus, R&D or subscriber acquisition costs (in sticky businesses) may be thought of as CapEx.
This might involve reinterpreting the CapEx that appears on the cash flow statement.
CapEx (CX from now on) has two components: maintenance capex (MCX), which a business has to reinvest just in order to stay in place, and growth capex (GCX), which is the part of CX that increases sales.
CX = MCX + GCX
MCX is a “cost”. GCX is an investment.
If you own a rental business for example, replacing a broken heater is MCX.
Buying a new rental property is GCX.
Warren Buffet’s owner’s earnings (OE) or Greenwald’s adjusted earnings try to account for this “cost” of doing business.
OE = NOPAT - MCX
Calculating MCX is both art and science. It is not a number that is directly broken out in financial statements. However, we can develop some intuition on how to think about it broadly, and estimate it.
For a mature company with stable sales (no growth or decline), there is no GCX. Thus, all CX is MCX. For such stable businesses, MCX is approximately equal to the depreciation.
MCX = depreciation
Another popular method uses the following algorithm:
- estimate the sales to capital ratio, SCR
- compute the change in sales dS = S(t) – S(t-1)
- GCX = dS/SCR
- MCX = CX – GCX
- average SCR over several years; compare with industry averages
- some CX may not produce sales growth immediately (ex. building a new theme park). This may involve projection, if the past doesn’t rhyme with the present.
- if stable or meaningful SCRs cannot be extracted, then be wary of the number you produce.