Showing posts with label maintainance capex. Show all posts
Showing posts with label maintainance capex. Show all posts

Friday 21 July 2017

Comparing average capex spending with depreciation and amortization.

1.   Where depreciation and amortization <<< capex

In some cases, the annual depreciation and amortization expense is a lot less than the average five- or  ten-year capex.#

This is the case in asset intensive companies.

When you see this, you have two good reasons against investing in them.  It should not be surprising that these companies

  • have very poor free cash flow track records and 
  • modest ROCE performances.

Avoid these companies, unless they have been able to produce a good ROCE whilst investing heavily.


2.  Where depreciation and amortization >>> capex.

Normally, you should be suspicious of companies with this kind of behaviour.

Is this a company that has been under-investing?

If yes, this could hurt its ability to make more money in the future.

However, you need to study the company's history on this issue to make sure that it is not under-investing.

Some companies have to spread the cost of things over their useful lives, (for example the costs of a TV channel such as licences, customer contracts, software and programme libraries), which don't need to be matched by outflows of cash every year.   



# As a rough rule of thumb, if the five-year capex figure is higher than the ten-year average, you should use the higher figure.

Calculating Owner Earnings of Buffett or the Company's Cash Profits

Buffett in his 1986 letter to shareholders described how he worked out what he called the "owner earnings".   

This is also referred to as the cash profits of a business.

Buffett believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.



How to calculate owner earnings or cash profits of a business?

Owner earnings are calculated as follows:

Owner earnings =   net income
                               + depreciation & amortisation
                               + other non cash item
                               - maintainance capital expenditure.


Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintainance, or stay in business, capex) often exceeded the depreciation and amortisation expense, and therefore profits were overstated.

Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintainance capex figure.



The difference between Owner Earning of Buffett and FCF

Generally speaking, in the owner earnings of Buffett or cash profits of a business, the calculation ignores changes in working capital that are included in free cash flow.



Hardest part of calculating owner earnings is estimating maintainance or stay in capex

The hardest part of this calculation is trying to estimate what maintainance or stay in business capex is.

As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this.

But the good thing is, you don't need to.

The whole purpose is to get a figure for the amount of cash needed to keep fixed assets in good working order so that you can then have a conservative estimate of cash profits to value a company

Basing your valuation on a conservative figure is more prudent and lowers your changes of paying too much for a share, which in turn lowers your investment risk.

(Additional notes below)



What to do when the owner earnings or cash profits of a business are negative?

If you come across a company that looks as if it is losing money when estimating its cash profits you need to either
  • do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or 
  • look for another share to buy.


Summary:

In summary, here is what you need to do in calculating owner earnings or company's cash profits:

1.  Take the company's most recent annual underlying or normalised net income/profit.

2.  Add back depreciation and amortization.

3.  Take away an estimate of stay in business capex.

4.  Divide by the weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.


Knowing a company's cash profits, we can use these to value shares.  




Additional Notes:

How do you get an estimate of stay in or maintainance business capex?

There are 3 reasonable methods:

1.  The company tells you.

Some companies are very good at simply stating what the figure is.  They give this figure in their annual reports.

2.  Use a multiple of the current depreciation or amortization expense.

Use a figure that is bigger than this, such as 120%.  This can be a reasonable estimate, sometimes.

For some companies, it can be way off if the cost of replacing assets is falling.

3.  Use a five or ten-year average of capital expenditure or capex.

This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.

This is a good approach to use if the company does not state the figure outright.





Monday 10 September 2012

Evaluating a Company - 10 Simple Rules

Having identified the company of interest and assembled the financial information, do the following analysis.

1.  Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity-type product?

2.  Do you understand how the company works?  Do you have intimate knowledge of, and experience with using the product or services of the company?

3.  Is the company conservatively financed?

4.  Are the earnings of the company strong and do they show an upward trend?

5.  Does the company allocate capital only to those businesses within its realm of expertise?

6.  Does the company buy back its own shares?  This is a sign that management utilizes capital to increase shareholder value when it is possible.

7.  Does the management spent the retained earnings of the company to increase the per share earnings, and, therefore, shareholders' value? That is, the management generates a good return on retained equities.

8.  Is the company's return on equity (ROE) above average?

9.  Is the company free to adjust prices to inflation?  The ability to adjust its prices to inflation without running the risk of losing sales, indicates pricing power.

10.  Do operations require large capital expenditures to constantly update the company's plant and equipment?   The company with low capital expenditures means that when it makes money, it doesn't have to go out and spend it on research and development or major costs for upgrading plant and equipment.


Once you have identified a company as one of the kinds of businesses you wish to be in, you still have to calculate if the market price for the stock will allow you a return equal to or better than your target return or your other options.  Let the market price determine the buy decision.  

Saturday 30 June 2012

A great company with a Durable Competitive Advantage will have a ratio of Capital Expenditures to Net Income of less than 25%. Less is better.


Capital Expenditures are expenses on:
  • fixed assets such as equipment, property, or industrial buildings
  • fixing problems with an asset
  • preparing an asset to be used in business
  • restoring property
  • starting new businesses
A good company will have a ratio of Capital Expenditures to Net Income of less than 50%. 
A great company with a Durable Competitive Advantage will have a ratio of less than 25%. 

Sunday 4 April 2010

Buffett (1986): The concept of Owners Earnings and Maintainance Capex


We got to know the master's views on his textile business. Let us go a year further and try to discuss what the guru has to say in his 1986 letter to shareholders.

The letter, as usual, though did contain quite a bit of commentary on the company's major businesses, it also had general investment related wisdom. This time around the master chose to speak on himself and his partner's role. This is what he had to say:

"Charlie Munger, our Vice Chairman, and I really have only two jobs. One is to attract and keep outstanding managers to run our various operations. This hasn't been all that difficult. Usually the managers came with the companies we bought, having demonstrated their talents throughout careers that spanned a wide variety of business circumstances. They were managerial stars long before they knew us, and our main contribution has been to not get in their way. This approach seems elementary - if my job were to manage a golf team - and if Jack Nicklaus or Arnold Palmer were willing to play for me - neither would get a lot of directives from me about how to swing."

"The second job Charlie and I must handle is the allocation of capital, which at Berkshire is a considerably more important challenge than at most companies. Three factors make that so - 
  • we earn more money than average; 
  • we retain all that we earn; and, 
  • we are fortunate to have operations that, for the most part, require little incremental capital to remain competitive and to grow. 
Obviously, the future results of a business earning 23% annually and retaining it all are far more affected by today's capital allocations than are the results of a business earning 10% and distributing half of that to shareholders. If our retained earnings - and those of our major investees, GEICO and Capital Cities/ABC Inc. - are employed in an unproductive manner, the economics of Berkshire will deteriorate very quickly. In a company adding only, say 5% to net worth annually, capital-allocation decisions, though still important, will change the company's economics far more slowly."

The master's non-interference in the management of the businesses he owned is now almost legendary. But just like the companies he invested in, he made sure that the people he put in charge had outstanding track records. Once that was done, he would completely move out of their way and let them manage the business. Indeed, when a business with favorable economics is run by an exceptional manager, the last thing one would want to do is upset the applecart. Yet again, while the line of thinking is simple yet extremely effective, it must have stemmed from the master's own experience of managing the operations of the textile business of Berkshire Hathaway. Having been at the wheels for years, he must have realised how difficult it is to successfully run a business and deliver knock out performances year after year.

Berkshire Hathaway, from the time Buffett has been at the helm, has never paid dividends to shareholders. This is because the master has always felt that he would be able to find a better use of capital than paying out dividends. And find he did! The returns that the company has generated for its shareholders have vastly exceeded returns by any other American company. A very difficult task indeed, especially over a very long period of time. He is also very right in saying that a company that earns above average returns and retains all earnings is likely to see its economics deteriorate much faster than a company retaining only 5% if the retained capital is not put to good use. In the end, the honours should definitely go to the company that makes the most effective use of capital.

The master rounded off the 1986 letter by introducing a concept of owner earnings, the one he frequently uses to evaluate companies. It is nothing but

(a) reported earnings plus 
(b) depreciation, depletion, amortization, and certain other non-cash charges minus
(c) the average annual amount of capitalised expenditures for plant and equipment that the business needs to fully maintain its long-term competitive position and current volumes.

While owner earnings looks similar to cash flow after capex and working capital needs, it does not take into account capex and working capital investment required for generating more volumes but instead takes into account capex that is required to maintain just the steady state operations. In other words, what we call as the maintenance capex. Since inflationary pressures can make maintenance capex look very large, analysts who do not consider it are bound to overestimate the worth of the company. In fact, this is what he has to say on those who do not consider the all-important (c) item in their evaluations.

"All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract (c). Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids - forever state-of-the-art, never needing to be replaced, improved or refurbished. Indeed, if all US corporations were to be offered simultaneously for sale through our leading investment bankers - and if the sales brochures describing them were to be believed - governmental projections of national plant and equipment spending would have to be slashed by 90%."