Estimating a company’s level of recurring capital expenditures is an important component of company analysis, being used to calculate both free cash flow and “owner earnings”, a concept discussed by Warren Buffett in some of his past annual reports.
Free cash flow is calculated as cash flow from operations adjusted for non-recurring items less recurring capital expenditures, whereas owner earnings is calculated as earnings adjusted for certain non-cash items, plus depreciation, less recurring capital expenditures (see Berkshire's (NYSE:BRK.A) 1986 AR).
Both free cash flow and owner earnings provide a useful check on a company’s reported earnings – if they are significantly different from reported earnings, then the reason for the difference should be investigated.
Although a company’s total (as opposed to recurring) capital expenditures can easily be found in their 10-K filings, these can in different cases give either an optimistic or pessimistic picture of the level of capital expenditures required to maintain the company’s production volume of a competitive product. Some companies do make an estimate of recurring capital expenditures, but this is the exception rather than the rule.
If a company does not break down capital expenditures into recurring and non-recurring components, the average ratio of recurring to total capital expenditures can be estimated by analyzing the company’s organic volume growth over a ten-year period. We use organic volume growth; otherwise acquisitions (particularly if late in the ten-year period) can distort the link between total capital expenditures over the period, production and manufacturing capacity. For Diageo (NYSE:DEO), a company that sells wine, beer, and spirits, organic volume is given in the annual report as cases shipped adjusted for the effects of acquisitions.
We estimate the ratio of recurring to total capital expenditures over a ten-year period because the delay between a capital expenditure made with the purpose of expanding production and the resulting increase in volume can vary. Consequently, the relationship between capital expenditures and production measured over a single year may not give much insight.
In our analysis, we assume that any percentage change in organic volume requires a corresponding percentage change in manufacturing capacity. Moreover, this percentage change in manufacturing capacity must be matched with a similar percentage change to property, plant, and equipment (PP&E).
It follows that we can impute a value for PP&E at the beginning of our measurement period by dividing the company’s current net PP&E by one plus the percentage increase in organic volume growth over the period. The difference between the company’s current PP&E and the imputed start value is an estimate of the cumulative capital expenditures used to expand the company’s productive capacity over the period.
Note that the actual PP&E at the start of the measurement period will often differ from the imputed value of PP&E at the start of the measurement period.
One reason for this is that PP&E sometimes increases because the minimum capital expenditures required for maintaining production volume has consistently exceeded depreciation; this would make the imputed PP&E at the start of the period greater than the actual net PP&E at the start of the period.
Another is that productivity improvements can sometimes increase volume without additions or improvements to PP&E; this would make the imputed PP&E at the start of the period less than the actual net PP&E at that time.
Our next step is to allocate a portion of the total capital expenditures equal to the difference between current net PP&E and the imputed starting value as accruing towards expansion, with the remainder being recurring. The procedure for estimating the amount of capital expenditures used for expansion over the time period is shown in the following equation, where PP&E is current net PP&E, VCurrent is the company’s current production volume, and VStart is the company’s production volume at the start of the time period adjusted for acquisitions.
Looking at this equation, we see that capital expenditures attributed to expansion increases with increasing volume over the period, and if volume is flat, the equation results in none of the capital expenditures being attributed to expansion. We can then estimate the company’s ratio of recurring capital expenditures to total capital expenditures over the period as:
I compared this estimate to two companies that disclosed their estimate of recurring capital expenditures, General Electric (NYSE:GE) (industrial operations only) and Wal-Mart (NYSE:WMT). In the case of General Electric in 2008, the estimated ratio of recurring to total capital expenditures was 83% as compared to a ratio of 70% disclosed in there 2008 10-K. For Wal-Mart, using data through FY 2009 resulted in an estimated ratio of 55% as compared to a disclosed ratio of 66%.
Part of the error for Wal-Mart is due to the abrupt slowdown in expansion; this made the historical relationship between recurring capital expenditures and total capital expenditures less indicative of the current situation.
Still, it is pretty close. Going back to FY 2008, our equation gives a ratio of recurring to total capital expenditures of 50% as compared to Wal-Mart’s stated ratio of 52%, and going back to FY 2007, our equation gives 46% as compared to Wal-Mart’s stated figure of 49%.
Table 3‑1 illustrates our estimating of the ratio of recurring capital expenditures to total capital expenditures for Consolidated Edison (NYSE:ED), Southern Company (SO, General Motors (NYSE:GM), Toyota Motor Company (NYSE:TM), The Coca-Cola Company (NYSE:KO), and 3M (NYSE:MMM).
For the two utilities, we estimated productive capacity by adjusting revenue by the urban electricity and gas index, a component of the consumer price index (NYSEARCA:CPI). For example, using 10 years of data, if 2008 revenue was $17,127M and the ratio of the urban electricity and gas index in 2008 to the index in 1999 was 1.68, we assumed that productive capacity in 2008 was $10,194M, i.e., the rest of the change in revenue was due to price increase rather than and increase in productive capacity.
Although both utilities had a different mix of electricity and gas revenues, the price of electricity and gas has similar increases over the period.
For Wal-Mart, we assumed that revenue growth is a good proxy for the growth in productive capacity, and consequently price increases were an insignificant contribution to revenue growth, which seems to be the case as the growth in the number of stores has only lagged revenue growth by 2%. This is small enough difference that it could be attributed to an increase in Super Centers as a percentage of total stores, which would increase the revenue per store.
For General Motors, we could not find consistent manufacturing volume, so we used unit sales as a proxy. Note that the Southern Company has a ratio of recurring to total capital expenditures of greater than one; this can be interpreted as meaning that the capital expenditures have not been sufficient to maintain productive capacity.
The average ratio of recurring to total capital expenditures over the ten-year period can be used to estimate recurring capital expenditures in a given year, which in turn can be used to calculate free cash flow in that year. Free cash flow ((NYSE:FCF)) in a given year i in a period of N years is calculated as the adjusted cash flow from operations in year i (AdjCashOps) less reported capital expenditures in year i (TotalCapex) multiplied by the ratio of the sum of recurring capital expenditures over the period to the sum of total capital expenditures over the period:
If you want a quick way to apply this technique of estimating a company’s recurring capital expenditures to a company you are analyzing, try out the software on my website.
Disclosure: I own shares in DEO, KO & MMM. I do not own shares of ED, SO, GM (which is now bankrupt), TM, or WMT.