Calculate Maintenance Capex in FCF


What You Will Learn

  • How to calculate maintenance capex in FCF to determine company equipment cost depreciation
  • How to calculate maintenance capex using actual companies

As you know, I try to approach stock analysis and business valuation with different methods in order to try and fill holes and weaknesses.

One aspect that I want to cover that I haven’t discussed before is regarding maintenance capital expenditures in Free Cash Flow (FCF) for the Discounted Cash Flow (DCF) valuation method.

Even now when it comes to FCF, I don’t worry about trying to calculate the exact details of maintenance capex, but going the extra mile to calculate maintenance capital expenditure will surely put you ahead of everyone else when it comes to uncovering hidden value.

Free Cash Flow Quick Recap

Free cash flow is the money generated that is not required to maintain operations. Simply, it is money that the business can use for whatever it wants. It can put it in the bank, give it to charity, pay a dividend, buy back shares or use it for future growth.

So when we use the simple version of the FCF formula

FCF = Net Cash from Operations – capital expenditures

we are calculating FCF by subtracting both the capital expenditure that is used to maintain operations and to fuel future growth.

(I am not talking about owner earnings here. Just the textbook FCF definition)

So in order to get an accurate FCF figure, the correct method would be to subtract ONLY the capital expenditure used to maintain the business.

What is Growth and Maintenance Capital Expenditure?

Maintenance Capex Explained

Maintenance Capex

Expenditures? – Maintenance Capex Calculation | Photo Wikipedia

As outlined above, maintenance capex is the money that is required to maintain or replace assets.

e.g. A typically high capex company such as oil drillers are required to service its rigs and replace parts just to stay in business.

Free Cash Flow attempts to differentiate between growth and maintenance but it is rare for companies to disclose what is used for maintenance and growth in their statements, nor is it required. This makes finding maintenance capex a difficult task.

Before I go on, let me say that finding maintenance capex is definitely an art. There is no strict formula or method and I have yet to come across a firm process to date.

If you have know of a better way, please leave a comment at the end.

How to Calculate Maintenance Capital Expenditures

The common method is to assume

Maintenance Cap Ex = Depreciation and Amortization

therefore

Free Cash Flow = Net Cash from Operations – D&A

The train of thought is that buildings and equipment will need to be replaced in the future and because depreciation is usually a straight line approach, it will also be much smoother.

By looking at several years of data, a capex number that is stable yet does not lead to increased revenues is a sign that it is mostly maintenance capex.

Determining Maintenance Cap Ex

Let’s look at the difference between three companies, JNJ, WMT and ATW. I chose these three companies as I figured their capex requirements would vary.

My reasoning is that JNJ should have lower capex since their intellectual property and patents equates to a low maintenance capex, such like MSFT. They also sell their products distribution channels which should also keep the maintenance capex down.

WMT owns and leases their stores, is required to purchase more inventory in their existing stores.

ATW is a heavy growth and capex company as it is a deep sea oil driller which requires an extensive amount of capital and credit for maintenance and growth.

in $mil 2005200620072008
JNJRevenues$50,514$53,324$61,095$63,747
D&A$2,093$2,177$2,777$2,832
Capex$2,632$2,666$2,942$3,066
WMTRevenues$312,427$348,650$374,526$405,607
D&A$4,717$5,459$6,317$6,739
Capex$14,563$15,666$14,937$11,499
ATWRevenues$176$276$403$527
D&A$27$26$34$25
Capex$26$79$91$328

So from the above number what do you see?

Notice how a non capex heavy,  stable cash cow business such as JNJ has D&A roughly similar to capex? JNJ has a very steady and minor increment in capex which also leads to a slow yet steady growth in revenues.

WMT is also similar. In 2008 we can estimate that their maintenance capex was $6,739m (D&A) which means that $4,760m was used for growth.

Lastly, we see that ATW has a fairly stable depreciation yet their capex growth is exponential. Now this is a sure sign of investing in growth and if you read and listen to the conference calls, they are building new and better rigs to add to their fleet.

Using depreciation and amortization as maintenance capital expenditure is also useful for when capex is erratic and FCF inconsistent, which is usually the case for companies like ATW and other industrial commodity businesses.

Another alternative is to normalize the capex or free cash flow, whichever is  easiest and then used the normalized number as the beginning point to your present value formula in the DCF valuation.

Bruce Greenwald also has a approach which I will get to in another post once I finish reading his book.

Disclosure

I own ATW at the time of writing

  • Borislav Koev

    Thank you for your very interesting article and your blog!

    but check this out!
    …any long-term car owner knows, it costs more to replace a ‘depreciated’ old vehicle with a modern equivalent.

    http://www.intelligentinvestor.com.au/articles/102/Crunching-cash-flow-ratios-.cfm?articleID=19600

    I have the same feeling that the Maintenance Capital Expenditure should be a bit higher than the depreciation. How high – I’m investigating at the moment.

    Regards,

    Borislav

  • @ Borislav
    Interesting point about the car replacement analogy but it’s important to remember the point that says: “So how does one overcome these discrepancies? By analysing this ratio over a period of several years, not just one. This way, you’ll be able to see the difference between the actual cash capex figure and the accounting depreciation.”

    Thanks for the link as well.

  • Hello,

    I have a question about your CAPEX calculation. You say that it = Depreciation and Amortization,, Yet in the example it it differs from D&A.. Please elaborate.

  • @ Micahel,

    I think you’ve misread something. I wrote that the common practice is to “assume” that capex = d&a. It’s an easy way of calculating if you quickly want to run the numbers.
    I use the Greenwald method in my spreadsheets.

  • KSK

    I had a question regarding capital expenditures while calculating the FCF for a particular year. Are capital expenditures forward looking metric? I get confused time and again , how they are calculated? After applying the formula for capital expenditure say for period 2010 and 2009 (Change in assets – change in liabilities) , the resulting Capex is subtracted from year 2009 to calculate FCF? i.e. FCF for year 2009 = net cash flows – capital expenditures (for year 2010)?

    Thank and regards,
    KSK

  • Hey KSK,

    Great question. If you split up capex by maintenance and growth, the maintenance part is going to be a current or past looking metric, whereas growth capex can be considered forward looking as it is going to add to future growth.

    But splitting it up is very difficult. Most companies will not mention it and there is no true formula. There are shortcuts, but there has never been an accurate way to calculate it other than to actually know what it is being used for. Something only management knows.

  • Rob Urban

    Buffett himself described “owner earnings” in 1986 as:
    “[Owner earnings] represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”

    “maintaining long-term competitive position” is a subjective statement, based on your deep understanding of the business. let’s say a company has $100M in PPE that is depreciating an average of $10M per year, but they are reinvesting in PPE to grow the business and without growth they will not be able to maintain their competitive position. look at the table below and determine what “maintain competitive position means”?

    Yr PPE Depr Capex Net Inc
    1 $100 $10 -$20 $10
    2 $120 $12 -$40 $15
    3 $160 $16 -$80 $20
    4 $240 $24 -$100 $25

    Pretty hard I think. You might use
    “Owner earnings” = net income + DDA + other non-cash charges – avg maintenance capex over 3-5 years. However, figuring out “maintenance capex” is not an easy task. If you have an easy way, please tell me. The formula you’ve given above for “owner earnings” is too simplified I think because it’s basically:

    owner earnings – cash flow from operations – depr & amort

    Using standard Free Cash Flow is much easier (and more conservative) than using “Owner Earnings” anyway. Using an average FCF over 3-5 years is an even better method. I always try to determine what a “base” FCF level is for a company. For example, for Dell I believe it’s $3B per year, AAPL it’s $30B.

  • definitely not easy to calculate maintenance capex.
    Here’s a way to do it. Not 100% fool proof but it’s better than most.
    http://www.oldschoolvalue.com/blog/valuation-methods/calculating-maintenance-capital-expenditure/

  • Rob Urban

    I think figuring out a “base” level of owner earnings is the key to determining a company’s true worth. I also tend to believe that Buffett wants to earn his 15% and this is what he is focused on. By focusing on a base maintenance level of owner earnings you are required to take a companies long-term competitive position into account as well (determine the size of the moat or sustainable competitive advantages).

    Bruce Berkowitz said: “the value of a stock is the amount of cash that the underlying company generates. cash is important, because it’s the only thing my family can spend. you run out of cash, you’re dead, whether a business or an individual. cash counts, so i count the cash. it’s not just any kind of cash, it’s the cash that an owner can keep after all the bills are paid and *after the capital used to maintain the franchise of the business*. once i have the cash count, i try to calculate it. when i have a range, i try to figure out how much on average a company can generate in cash. the bad years, the good years, what’s normal? what should you expect over a cycle? and then, i try and kill it. what can stop the cash from coming in? what can kill the company? i then take the calculation and compare it with the price of the stock. because investing, after all, is nothing more than comparing what you give to what you get in the future. i try to figure out if there is a margin of safety. can i get hurt? am i buying this stuff cheap enough

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