The Capital Expenditure Budget

This is extremely significant in some companies, less so in others.

It will list all the planned capital expenditure showing the date when the expenditure will be made, and the date that the expenditure will be completed and the asset introduced to the business.

Major contracts may be payable in installments and the timing is important to the cash budget.

A sum for miscellaneous items is usually necessary.  For example, major projects might be listed separately and then $15,000 per month added for all projects individually less than $5,000.

Within the capital expenditure budget, timing is very important.

Expenditure affects cash and interest straight away.

Depreciation usually starts only on completion.

How do you identify an exceptional company with a durable competitive advantage from the CASH FLOW STATEMENTS?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.

CASH FLOW STATEMENTS

The cash flow statement keeps track of the actual cash that flows in and out of the business.

A company can have a lot of cash coming in, through the sale of shares or bonds and still not be profitable.

A company can be profitable with a lot of sales on credit and not a lot of cash coming in.

The cash flow statement will tell us if the company is bringing in more cash than it is spending (“positive cash flow”) or if it is spending more cash than it is bringing in (“negative cash flow”).

Cash flow statements like income statements cover a set period of time.

The cash flow statement has three sections:

·               Cash flow from operating activities

·              Cash flow from investing activities

·              Cash flow from financing activities

Cash flow from operating activities

Net income + depreciation & amortization = Total Cash from Operating Activities

Depreciation and amortization are real expenses from an accounting point of view.

They don't use up any cash because they represent cash that was spent years ago.

Cash flow from investing activities

This area includes an entry for all capital expenditures made for that accounting period.

Capital expenditure is always a negative number because it is an expenditure which causes a depletion of cash.

Total Other Investing Cash Flow Items adds up all the cash that gets expended and brought in, from the buying and selling of income producing assets.

If more cash is expended than is brought in, it is a negative number.

If more cash is brought in than is expended, it is a positive number.

Capital Expenditure + Other Investing Cash Flow Items = Total Cash from Investing Activities

Cash flow from financing activities

This measures the cash that flows in and out of a company because of financing activities.

This includes all outflows of cash for the payment of dividends.

It also includes the selling and buying of the company’s stock.

When the company sells shares to finance a new plant, cash flows into the company.

When the company buys back its shares, cash flows out of the company.

The same thing happens with bonds.

Sell a bond and cash flows in; buy back a bond and cash flows out.

Cash Dividends Paid + Issuance (Retirement) of Stock, Net + Issuance (Retirement) of Debt, Net  = Total Cash from Financing Activities

Net Change in Cash

Total Cash from Operating Activities + Total Cash from Investing Activities + Total Cash from Financing Activities = Net Change in Cash

Some of the information found on a company’s cash flow statement can be very useful in helping us determine whether or not the company in question is benefiting from having a durable competitive advantage.

Capital Expenditures

Capital expenditures are outlays of cash or the equivalent in assets that are more permanent in nature – held longer than a year – such as property, plant and equipment.

They also include expenditures for such intangibles as patents.

They are assets that are expensed over a period of time greater than a year through depreciation and amortization.

Capital expenditures are recorded on the cash flow statement under investment operations.

When it comes to making capital expenditures, not all companies are created equal.

Many companies must make huge capital expenditures just to stay in business.

If the capital expenditures remain high over a number of years, they can start to have deep impact on earnings.

As a rule, a company with durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage.

Coca Cola spent 19% of its last ten years total earnings for capital expenditure.  Moody spent 5% of its total earnings for the last ten years for capital expenditure.

GM used 444% more for capital expenditure than it earned over the last ten years.  Goodyear (tire maker) used 950% more for capital expenditure than it earned over the last ten years.

For GM and Goodyear, where did all that extra money come from?

It came from bank loans and from selling tons of new debt to the public.

Such actions add more debt to these companies’ balance sheets, which increases the amount of money they spend on interest payments and this is never a good thing.

Both Coke and Moody’s, however, have enough excess income to have stock buyback programs that reduce the number of shares outstanding, while at the same time either reducing long-term debt or keeping it low. 

Both these activities helped to identify the businesses with a durable competitive advantage working in their favour.

When looking at capital expenditures in relation to net earnings, add up a company’s total capital expenditures for a ten year period and compare the figure with the company’s total net earnings for the same ten year period.

The reason we look at a ten year period is that it gives us a really good long term perspective as to what is going on with the business.

Historically, durable competitive advantage companies used a far smaller percentage of their net income for capital expenditures.

If a company is historically using 50% of less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage.

If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favour.

Stock Buybacks

Companies that have a durable competitive advantage working in their favour make a ton of money.

The companies can sit on this cash, or they can reinvest it in the existing business or find a new business to invest in. 

If they don’t require the cash for the above, they can also either pay it out as dividends to their shareholders or use it to buy back shares.

Shareholders have to pay income tax on the dividends.  This doesn’t make anyone happy.

A neater trick is to use some of the excess money that the company is throwing off to buy back the company’s shares.

This reduces the number of outstanding shares – which increases the remaining shareholders’ interest in the company – and increases the per share earnings of the company, which eventually makes the stock price go up.

If the company buys back its own shares it can increase its per share earnings figure even though actual net earnings don’t increase.

The best part is that there is an increase in the shareholders’ wealth that they don’t have to pay taxes on until they sell their stock.

To find out if a company is buying back its shares, go to the cash flow statement and look under Cash from Investing Activities, under a heading titled “Issuance (Retirement) of Stock, Net”.

This entry nets out the selling and buying of the company’s shares.

If the company is buying back its shares year after year, it is a good bet that it is a durable competitive advantage that is generating all the extra cash that allows it to do so.

One of the indicators of the presence of a durable competitive advantage is a “history” of the company repurchasing or retiring its shares.

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%. 

Less is better.


http://equitybondtheory.com/cash-flow/capital-expenditures

Corporate Finance - Factors that Influence a Company's Capital-Structure Decision

The primary factors that influence a company's capital-structure decision are:

1.Business risk
2.Company's tax exposure
3.Financial flexibility
4. Management style
5.Growth rate
6.Market Conditions

1.Business RiskExcluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.

As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has less risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.

2.Company's Tax ExposureDebt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.

3.Financial FlexibilityThis is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has.

The airline industry is a good example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top.

4.Management Style Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).

5.Growth RateFirms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate.

More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise.

6.Market ConditionsMarket conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/capital-structure-decision-factors.asp#ixzz1yevRPv00

Using Free Cash Flow

Company ABC.

1995  Earnings    $100,000        FCF -$7.0 million
1996  Earnings    $5.9 million      FCF -$28.0 million
1997  Earnings    $12.3 million    FCF -$57.4 million

Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  


Company OPQ.

1997  Earnings    $6,945 million     FCF  +$5,507 million
1998  Earnings    $6,068 million     FCF  +$5,634 million
1999  Earnings    $7.932 million     FCF  +$7,932 million 

Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.

Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.   


Company DEF

1996   Earnings   $1,473 million   FCF  - $2,532million
1997   Earnings   $787 million      FCF  - $2,347 million
1998   Earnings   $  28 million      FCF  - $2,187 million

Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.

Company DEF spends an amount equal to about 20% of its long-term assets in a single year.


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How to use Free Cash Flow (FCF)?


Think of FCF as another bottom line.


Good and great companies generate lots of positive FCFs.


Negative FCF isn't necessarily bad, but it suggests you're dealing with either a speculative investment (such as Company ABC) or an underperformer (such as Company DEF).


Above all, negative FCF or a high level of capital spending naturally raises other questions.

1. If the company is spending so much money, is it at least earning a high premium on that capital?
2. And is all that spending paying off in rapid sales and profit growth?

If you are a careful investor, you'll want to know the answers to those questions before letting the company spend your money.

Big Capital Spending and Cash Flow Can Work Together

Company ABC.

1995  Earnings    $100,000        FCF -$7.0million
1996  Earnings    $5.9million      FCF -$28.0million
1997  Earnings    $12.3million    FCF -$57.4million


Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.




Company OPQ.



1997  Earnings    $6,945million     FCF  +$5,507million
1998  Earnings    $6,068million     FCF  +$5,634million
1999  Earnings    $7.932million     FCF  +$7,932million 


Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.






Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  


Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.  


Both Company ABC and Company OPQ spend vast sums relative to their asset bases.  However, we see a big difference when we look at their respective FCFs.

• These positive FCFs mean Company OPQ has money left over even after its large capital-spending budgets.  
• By contrast, Company ABC, must turn to investors or lenders to make up the difference.  Only by selling new shares to the public or taking out a loan can Company ABC fund its aggressive spending.

Growth in profits have LITTLE role in determining intrinsic value.

Growth in profits have LITTLE role in determining intrinsic value.  It is the amount of capital used that will determine value.  The lower the capital used to achieve a certain level of growth, the higher the intrinsic value.


Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraph will surely make the reader a much better investor.

Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value.

There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines.

Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.

****Buffett (1992): Do not categorise stocks into growth and value types, the two approaches are joined at the hip

Warren Buffett's 1992 letter to his shareholders touched upon his views on short-term forecasting in equity markets and how it could prove worthless. In the following few paragraphs, let us go further down through the letter and see what other investment wisdom he has on offer.

Most of the financing community puts stock investments into one of the two major categories viz. growth and value. It is of the opinion that while the former category comprises stocks that have potential of growing at above average rates, the latter category stocks are likely to grow at below average rates. However, the master belongs to an altogether different camp and we would like to mention that such a method of classification is clearly not the right way to think about equity investments. Let us see what Buffett has to say on the issue and he has been indeed very generous in trying to put his thoughts down to words.

"But how, you will ask, does one decide what's 'attractive'? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: 'value' and 'growth'. Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term 'value investing' is redundant. What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

Whether appropriate or not, the term 'value investing' is widely used. Typically, it connotes the purchase of stocks having attributes such as 

• a low ratio of price to book value, 
• a low price-earnings ratio, or 
• a high dividend yield. 

Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

Correspondingly, opposite characteristics - 

• a high ratio of price to book value, 
• a high price-earnings ratio, and 
• a low dividend yield 

- are in no way inconsistent with a 'value' purchase.

Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraphs will surely make the reader a much better investor. We believe the most important takeaways could be as follows:

• Do not categorise stocks into growth and value types. A high P/E or a high price to cash flow stock is not necessarily a growth stock. A low P/E or a low price to cash flow stock is not necessarily a value stock either. 
• Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value. 
• There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines. 
• Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.
  
  
  
  
  http://www.equitymaster.com/detail.asp?date=12/20/2007&story=2

Why All Earnings Are Not Equal

Why All Earnings Are Not Equal

By GRETCHEN MORGENSON
Published: January 9, 2010

AFTER a rip-roaring performance in 2009, the stock market has continued its upward climb. A reason to celebrate? Sure. But also a good time to check whether a company in which you have a stake keeps its books in a way that reflects reality.

When the market is roaring and the economy isn’t, executives come under increased pressure to make sure that their companies’ results justify higher valuations. That’s why smart investors keep an eye on them, by scrutinizing how their profits are figured.

Such is the view of Robert A. Olstein, a veteran money manager who dissects financial statements to uncover stocks he thinks other investors are valuing improperly. Since 1995 he has overseen the Olstein All-Cap Value fund, and although he had a horrific 2008 (down 43 percent), his 14-year results exceed the Standard & Poor’s 500-stock index by an average of 3.25 percent annualized, net of fees.

Mr. Olstein’s 2008 troubles have made him more determined than ever to scrub companies’ results. “As the market goes higher, it becomes more important to measure the quality of corporate earnings,” he said. “You have to look behind the numbers.”

Adjustments that investors need to make now, in Mr. Olstein’s view, are a result of disparities between a company’s reported earnings and its excess cash flow. Earnings are what investors focus on, but because these figures include noncash items, based on management estimates, the bottom line may not tell the whole story.

Cash flow, on the other hand, is actual money that a company generates and that its managers can use to invest in the business or pay out to shareholders.


SOME of the widest gulfs between earnings and cash flows, Mr. Olstein said, are showing up the ways companies account for capital expenditures.

To ensure growth, companies invest in things like new facilities or additional equipment. As time goes on, plants and equipment lose value — the way a car does the moment you drive it away from the dealer — and companies are allowed to write off a portion of these values each year based on management estimates of how long they will generate revenue.

The write-offs are known as depreciation, and the more a company chooses to write off, the greater its earnings are reduced. So managers interested in plumping their profits may depreciate less than they otherwise would or should. Conversely, heavy depreciation amounts can make earnings appear more depressed than the company’s cash flows indicate.

“It’s an investor’s job to determine the economic realism of management’s assumptions,” Mr. Olstein said. “There is nothing illegal here, but maybe their depreciation assumptions are unrealistic.”

One way to assess the accuracy of management’s estimates is to compare, over time, how much a company spends on new plant and equipment and how much it deducts in depreciation each year. Some of the discrepancies that emerge can be temporary, caused by the lag time between an initial investment and subsequent write-downs for depreciation.

Companies in a growth phase, for instance, will show greater capital expenditures than depreciation as they increase investments in plant and equipment.

But that should be only temporary. If such discrepancies appear on a company’s books year in and out, then investors might well question the depreciation assumptions. Investors confronted by large disparities should discount those companies’ earnings by the amount of excess capital expenditures. Such an exercise reveals how much free cash flow is available to stockholders.

Conversely, if depreciation exceeds capital expenditures, Mr. Olstein says that the earnings at these companies are actually better than they appear — and that this shows up in the cash flows.

Mr. Olstein has spotted several companies whose depreciation and capital expenditures have shown significant discrepancies in recent years. For some, heavy depreciation schedules are punishing earnings temporarily. At other companies, modest depreciation means earnings look better than cash flows.

Two retailing companies provide examples of how depreciation can hurt earnings but mask solid cash flows. They are Macy’s and Home Depot, and both are coming off recent expansion programs that are still being felt in the financials, Mr. Olstein said. He owns both in his fund.

Macy’s earned just a penny a share in the first nine months of 2009 but generated per-share cash flow of $1.41. Home Depot posted per-share profits of $1.40 for the period, while its cash flow reached $1.87 a share.

The flipside is represented by companies like railroads where depreciation is not keeping up with spending. Railroad operations are capital intensive, to be sure, but for the last four years, some companies’ expenditures have exceeded their write-downs by significant margins.

For instance, Union Pacific put $3.64 a share into capital expenditures in the first nine months of 2009. But its depreciation during that period totaled just $2.12 a share. In 2008, the company spent $5.40 a per share in capital expenditures compared with $2.69 in depreciation. Since 2005, Union Pacific has recorded $17.81 a share in capital spending but has depreciated about half that much — just $9.54 a share.

“The railroads are not bad businesses, but their stocks are overpriced when you look at what their cash flows are,” Mr. Olstein said. For the first nine months of last year, Union Pacific’s free cash flow was 99 cents a share; earnings were $2.51.

Another company with a sizable gap between depreciation and capital expenditures is the Carnival Corporation, the cruise ship company. Over the last four years, it has spent $16.48 a share on assets but it has written down just $6.01 a share.

Donna Kush, a Union Pacific spokeswoman, said it’s common for capital spending to exceed depreciation in her industry. “When you have long-life assets, you will have a mismatch,” she said, “because we need to constantly upgrade for safety and to serve our customers.”

And David Bernstein, chief financial officer of Carnival, said that at some point his company’s growth would wind down and its capital expenditures and depreciation would be more aligned. But in the meantime, he said, it is “simplistic” to expect the two figures to match up.

Still, Mr. Olstein said consistent gulfs between capital spending and depreciation should concern investors. “If it keeps on deviating then you have to look at why,” he said. “You have to reconcile the differences or the market will do it for you.”

http://www.nytimes.com/2010/01/10/business/economy/10gret.html?ref=business

Airline Capital Expenditure

This is one of the many reasons for avoiding airline stocks.  It is a tough industry to be in.