CAPEX: Look for companies where the capex ratio is consistently below 30%

Quality companies produce high ROCE (at least 15%) and lots of free cash flow because they don't need to spend much money on new assets in order to grow.

Capex Ratio

                              Capex ratio = capex / operating cash flow

This ratio compares the amount of cash a company ploughs back into tits business through capex to the amount of cash coming into the business - its operating cash flow.

It is very easy to calculate a capex ratio for a company, using its cash flow statement.

Low capex ratio (< 30%).

The lower this ratio, the less capital intensive a company is and the better chance it has of producing lots of free cash flow and a high ROCE. 

Look for a capex ratio of lower than 30%.

Non-financial companies with low capex ratios, generally also have very high ROCE figures as well.

High capex ratio (>30%).

Companies with high capex ratios tend to have a very low ROCE.  Generally, companies with capex ratios of 30% or more tend not to produce very high ROCE.

A high capex ratio is sometimes necessary in order to give a company the scope to grow.  This is not usually a problem, as capex will tend to fall back afterwards.  However, when the capex ratio is consistently high year after year, this is a warning sign for investors.

Shell (High capex ratio) versus Domino's (Low capex ratio) for 2006 to 2015

Company Shell consistently ploughed more than half its operating cash flow back into its business with capex for 2006 to 2015.  This consistently high capex ratio - along with volatile oil prices - meant that its free cash flow moved around all over the place in this period.

Domino's capex ratio from 2006 - 2015 were mainly below 30%, except in 2008 and 2009 when it was 45% and 60% respectively.  Domino's capex ratio has declined significantly since 2008 and 2009 (when the company was investing in new distribution centers to help grow the business).  Company Domino's capex ratio is now less than 10% and in 2015 was 8.45%.  

In the ten years to June 2016, Domino's trounced Shell as an investment.  Domino's returned nearly 660%, compared with just 63% for Shell.   The divergent share price performance of the two companies was not  a surprise given what we now know about the importance of free cash flow in quality companies.