Capex

Capex (an abbreviation for Capital Expenditure) is the money a company uses to acquire, upgrade, and maintain its physical assets. Think of it as the company’s investment in its own foundation and future. These aren't the everyday running costs like salaries or utility bills (that's Opex, or Operating Expenses); instead, Capex covers the big-ticket, long-term items. This includes purchasing new machinery, constructing a new factory, upgrading its IT systems, or even buying a new fleet of delivery trucks. For a value investor, understanding Capex is critical because it reveals how much cash a company must reinvest simply to stay in business, and how much it's betting on future growth. You'll find this crucial figure on a company's cash flow statement, where it tells a story about management's long-term strategy and financial discipline.

At its core, Capex is a choice about the future. A company can either spend money to maintain its current operations or spend it to expand them. This distinction is the key to analyzing a company's health and prospects.

Imagine you own a pizza shop. The money you spend to fix a leaky roof or replace a worn-out oven is Maintenance Capex. It's the cost of staying in the game. You have to spend this money just to keep making pizzas at the same rate. It doesn't grow your business, but without it, your business would shrink. Now, if you buy a second, larger oven to double your output or purchase the storefront next door to expand your seating area, that's Growth Capex. This is a discretionary investment made with the expectation of generating more profit in the future. For an investor, the goal is to find companies that don't have to spend a fortune just to stand still. A business with low maintenance capex has more money left over for exciting things, like expanding, paying down debt, buying back stock, or paying you a dividend.

The real analytical work begins when you dive into the financial statements, as companies rarely label their spending as “maintenance” or “growth.”

The most direct place to find total Capex is the cash flow statement, under the “Cash Flow from Investing Activities” section. It's usually listed as “Purchase of property, plant, and equipment” or a similar line item. You can also find clues on other statements:

• The balance sheet shows the value of a company’s Property, Plant, and Equipment (PP&E). A significant year-over-year increase often points to heavy Capex spending.
• The income statement contains a non-cash charge called depreciation, which represents the “using up” of assets over time. This figure is a vital component in estimating maintenance capex.

Since companies don't split it out for us, we have to become financial detectives. Here are two common methods to estimate the breakdown.

Popularized by Columbia Business School professor Bruce Greenwald, this method is more precise and connects spending to sales growth.

1. Step 1: Find the ratio of assets to sales for a stable period. Calculate the average gross property, plant and equipment (Gross PP&E) to sales ratio over the last 5-7 years. (Gross PP&E can be found in the footnotes of the annual report).
2. Step 2: Determine the sales growth for the most recent year.
3. Step 3: Estimate Growth Capex by multiplying the average asset-to-sales ratio from Step 1 by the sales growth from Step 2. `Growth Capex = (Avg. Gross PP&E / Sales Ratio) x (Increase in Sales)`
4. Step 4: Estimate Maintenance Capex by subtracting your estimated Growth Capex from the total Capex figure found on the cash flow statement. `Maintenance Capex = Total Capex - Growth Capex`

A much simpler, though less accurate, shortcut is to use the depreciation expense as a rough estimate for maintenance capex. The logic is that depreciation is the accounting cost of an asset wearing out, so the cost to replace it should be roughly similar. Warning: This is an approximation. In reality, inflation and technological advances mean the replacement cost for an asset is rarely the same as its original cost or accumulated depreciation. However, for a quick first look, it's a useful rule of thumb.

For a value investor, Capex isn't just a number; it's a measure of a company's fundamental business model and management's skill.

Value investors often dream of “capital-light” businesses—companies that require very little maintenance capex. A software company, for example, can serve a million new customers with minimal additional investment compared to a steel mill, which needs massive and constant reinvestment in its foundries and machinery. Capital-light companies are fantastic because they generate more free cash flow (FCF), which is the cash left over after all expenses, including Capex, are paid. The basic formula is `FCF = Operating Cash Flow - Capex`. A lower Capex figure directly translates into a higher FCF, giving the company more financial flexibility.

When analyzing a company's Capex, look for these signals:

• Red Flags:
  • Capex Exceeds Operating Cash Flow: If a company is spending more on Capex than it's generating from its core business, it may be funding basic maintenance with debt. This is unsustainable.
  • High Spending, No Growth: Be wary if a company consistently posts high Capex figures without a corresponding increase in revenue or profit. This may signal poor decision-making by management—what value investors call poor capital allocation.
  • Sudden Capex Cuts: A dramatic drop in Capex might temporarily boost FCF, but it could mean management is neglecting vital maintenance to make the short-term numbers look good.
• Green Lights:
  • Productive Growth Spending: A company that spends heavily on growth capex and shows a rising return on invested capital (ROIC) is a sign of a brilliant management team creating shareholder value.
  • Low and Stable Maintenance Needs: A business that can maintain its competitive position with minimal reinvestment is a potential cash-generating machine.
  • Clear Communication: Look for management teams that clearly explain their Capex plans and the expected returns on their investments in annual reports and shareholder letters.