The expected value of a stock should increase in direct proportion to the capex budget. But how reliable is capex growth as predictor of a stock’s future returns?
The stock market has always treated capital investments of publicly listed companies as a sign of growth. Fund managers and analysts use the level of capital expenditures, or CapEx, to forecast a stock's future profitability because earnings growth comes from expansion.
The past two years have seen subdued capital spending by the private sector as well as the government owing to the pandemic and lockdowns. This is now expected to change. Lately, we have witnessed major CapEx announcements across sectors. Private CapEx is now witnessing a boom as the demand revives, said analysts.
There is quite a bit you should know before you dive in. If you want to ride the CapEx trend to invest in stocks, here is a quick guide.
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What is CapEx?
The cash that businesses spend to buy, improve, or prolong the life of an asset is known as capital expenditure (CapEx). The purpose of capital investments is to improve the company's long-term financial stability. The assets purchased through capital expenditures are long-term investments with a useful life of at least one year.
Even though the costs are advantageous to a business, they frequently involve a sizable financial investment. In order to efficiently create the revenue required to pay the cost of the capital expenditure, businesses must effectively budget.
A corporation will frequently use capital investments to boost operational effectiveness, boost long-term revenue, or upgrade its current assets. When compared to other sorts of expenditure, such as overhead costs or payments to suppliers and creditors, which concentrate on short-term operating costs, capital spending is different.
The capital expenditures of a firm are widely watched by investors and analysts because they might reveal if top management is investing in the long-term viability of the business.
How to Calculate Net Capital Expenditure (CapEx)
If you have access to a company's cash flow statement, you can just look at the capital expenditures that were made in the investing cash flow section without performing any calculations.
If depreciation is separated out on the income statement and you don't have access to the cash flow statement, you can still determine the net capital expenditure (which most, but not all, companies do).
Follow these steps to calculate capital expenditures (CapEx):
- Locate depreciation and amortization on the income statement
- Locate the current period property, plant & equipment (PP&E) on the balance sheet
- Locate the prior period PP&E on the same balance sheet
- Use the formula below to arrive at CapEx
CapEx Formula
The CapEx formula from the income statement and balance sheet is:
CapEx = PP&E (current period) – PP&E (prior period) + Depreciation (current period)
This formula is derived from the logic that the current period PP&E on the balance sheet is equal to the prior period PP&E plus capital expenditures less depreciation.
CapEx and Depreciation
Over the course of the fixed asset's useful life, depreciation is utilized to cost it. Instead of deducting the entire cost of an asset in the year it is purchased, depreciation helps to spread the cost out over several years. Until the asset's useful life is through, depreciation enables businesses to profit from the asset while deducting a portion of its cost each year.
For instance, if an asset costs $10,000 and is anticipated to be used for five years, depreciation may be charged at the rate of $2,000 per year for the following five years. Depreciation can be calculated using several different techniques. Costs that aren't capital outlay must be deducted in full the year they're incurred.
CapEx Limits
There are capitalization limits, which specify that the price of assets must be greater than to be depreciated over time rather than charged entirely as an expense in the current year. The cost of record-keeping associated with depreciation causes capitalization limits to be put into effect. Costs that are not depreciated and are associated strictly with operational matters are known as operational expenditures.
Types of Capital Expenditures (CapEx)
Below are some of the common types of capital expenditures, which can vary depending on the industry.
Buildings and Property
A building or property upgrade would be seen as a capital acquisition since the asset will be used for many years. Secured debt or a mortgage, for which the payments are made over a long period of time, is frequently used to facilitate the purchase of the real estate, machinery, and equipment. Between what is a repair (not extending the asset's useful life) and a capital upgrade, there is a fine line.
Both the cost of the asset and the interest payments connected with debt financing may be discounted. Costs related to the issuance of stock, however, would not be eligible for depreciation.
Upgrades to Equipment
Equipment used to manufacture things in the manufacturing sector and other sectors may become dated or just wear out. The equipment frequently requires upgrades. The costs of these changes should be discounted over time if they exceed the capitalization limit that is currently in place. Equipment upgrades are frequently financed, just like buildings or other real estates. It's possible to deduct the cost of this loan as well.
Software Upgrades
For large businesses, software costs are a considerable expense. Software upgrades and purchases are classified as capital expenditures (CapEx) and may be discounted under certain conditions. According to accounting guidelines, some internal R&D costs associated with developing new software must be capitalized and written down over the asset's life. The costs of long-term software, fees paid to other parties who helped with the development of the software, wages for staff members who worked on it, and travel related to it are a few examples.
Computer Equipment
If it meets the necessary requirements, technology, and computer equipment, such as servers, laptops, desktop computers, and peripherals, would be considered capital expenditures. The usable life of the equipment must be longer than a year. Additionally, a business may establish an internal materiality threshold to avoid capitalizing any calculator bought and kept for longer than a year.
Vehicles
For distribution purposes or to provide services to consumers, such as delivery services, businesses frequently require a fleet of cars. Whether they were bought outright or financed with debt, these cars are regarded as capital expenditures. Leasing charges for automobiles, however, are regarded as operational costs.
Intangible Assets
Assets for capital expenditures don't always have to be real or physical; they can also be intangible. A company's acquisition of a patent or license might qualify as a capital expense.
What Capital Expenditure Means to Investors
Investors can assess a company's management of firm capital by understanding CapEx. The ability to assess accountability and responsibility for the strategy and implementation of financial decisions that affect an organization's profitability is perhaps of greater importance to investors. Investors can assess how managers are using capital for potential future expansion.
Investors can determine whether and how a company is acquiring long-term assets by analyzing the information on financial statements, such as PP&E expenditures on a balance sheet and depreciation on an income statement. They can assess whether an asset's worth is rising as a result of additions, which might suggest to investors that a company is using its existing cash flow to fund plans or projects for operations expansion.
When reviewing a cash flow statement, investors should look for a negative cash flow in the investing area. This indicates that current cash flows are being used for long-term investments.
Individual investors are aware that prudent short-term spending management enables them to take advantage of and engage in investment opportunities that will result in long-term wealth growth. For investors, a company's capacity to effectively manage both the risk and return of capital investments as well as short-term operating expenditures has an impact on long-term firm value. A vital skill component that helps investors better comprehend a firm's operations and, more crucially, how those operations may affect shareholder value, is understanding terms like capital expenditures.
How do capital expenditures affect stock returns?
As shown above, if there is an increase in the demand for a product then companies are unable to match the supply. This leads to companies increasing their capacities to expand production. An increased supply then leads to increased sales which in turn creates value for its shareholders.
In the short-term horizon, a company might see margin compression due to investments in CapEx. The same start easing as soon as a company starts production from new factories. This makes that company value accretive for its shareholders in the medium to long term.
How reliable is CapEx growth as a predictor of a stock’s future returns?
Let’s assume we define CapEx growth as the increase in net fixed assets. We then correlate this increase in CapEx as a percentage of total assets with the corresponding stock returns after one year.
Experts discovered that listed companies that make significant capital investments typically have poorer stock returns in the future.
This implies that the likelihood that a company may experience negative stock returns after a year increase with the size of the capital expenditure it makes.
Why do capital investments, which are meant to boost earnings, often result in poorer stock returns?
Always keep in mind that every business has a minimum rate of return that it expects from each endeavor. This return, also known as the hurdle rate, is an indication of the company's potential cost in the current risk climate.
An organization will need a high internal rate of return (IRR), which can cover its hurdle rate if a project is hazardous. By ensuring that the present value of a project's cash flows can more than cover its initial investment outlay, it can also take the form of net present value, often known as the NPV.
The risks associated with a company's CapEx include the possibility that it won't create enough returns to achieve its hurdle rate. The risk grows with CapEx size since bigger CapEx takes longer for a company to recover its investment, increasing the likelihood that a positive NPV or IRR will not be realized.
As a result, since the market factored uncertainty into share prices, larger risks result in poorer stock returns. Low market confidence could potentially be the cause of the negative link between CapEx and stock returns.
For instance, if shareholders believe management is mismanaging the company's funds by excessively allocating its resources, which may not always be in their best interests, the share price may decline as a result of the capital investment.
Similarly, investors could not agree with management's decision to move through with particular projects. By overestimating its rates of return, management could unintentionally take on initiatives that have a negative NPV.
Keep in mind that ventures with negative NPV don't always end in losses. An investment can bring in money for the business and perhaps increase overall profits. Simply said, given the project's hurdle rate, the present value of the increased earnings does not support the company's capital investments, which lowers shareholder value.
While capital expenditures may undoubtedly boost a company's profits potential, the return on capital should be our primary concern because only positive NPV capital expenditures can support sustained share price growth.
Summary of CapEx (Capital Expenditures)
Capital expenditures typically entail a substantial outlay of funds or capital, necessitating the utilization of debt. Investors closely watch how much debt a company is taking on to make sure the money is being used properly because capital expenditures are pricey.
Poorly planned or carried-out capital expenditures might potentially result in future financial issues. For instance, if a company's management team invests in cutting-edge technology that quickly becomes outdated, the business may be saddled with loan payments for years without seeing much return on the asset.
Some industries require more capital than others, like the oil (see Oil forecast and price predictions) and gas (see Natural Gas forecast and price predictions) sectors where businesses must purchase drilling equipment. Investors should therefore compare a company's capital expenditures to those of other businesses operating in the same industry.
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Sources:
Capital expenditure - Wikipedia
Capital Expenditure (Capex) - Guide, Examples of Capital Investment (corporatefinanceinstitute.com)
Capital Expenditure (CapEx) Definition, Formula, and Examples (investopedia.com)
What Is Capital Expenditure (CapEx)? (thebalancemoney.com)