I discussed about maintenance capex and its relation with Free cash flow. To recap

Free cash flow = Net earnings + depreciation – maintenance capex

And free cash flow is the money the owner of business can take out or re-invest in the business.

Maintenance capex however does not have a precise formulae. That does not mean you cannot calculate it. But as you can see, if valuation is based on free cash flow which itself is based on an imprecise measure such as maintenance capex, it cannot be precise in itself.

Valuation depends on free cash flow, project growth rates , terminal value and the discount rates. All these are estimates and hence valuation is itself an estimate. That is the reason I find it assuming when analysts give reports where they give precise valuation targets and on top of that even the duration (next one year !!) when the target would be met.

So, coming back to maintenance capex, how do I estimate it? let me warn you at the outset. My approach is self developed, imprecise and only roughly right.

I will use my valuation template to explain my approach

Worksheet – anal – In this worksheet I fill up the sales, depreciation, wcap etc. On line 26, I calculate the additional capex (additional fixed asset and Wcap for the year). Line 27 is capex as % of sales. This gives me a capex trend (total) for a period of time for the business. I then use this trend to estimate the maintenance capex.

For ex: if the business has an asset turn (on average) of 2, then I would assume capex as 2.5% of sales

Sales = 100
Asset = 50
Inflation increase in sales = 5
Corresponding asset required = 2.5 (2.5% of sales)

If the business is asset heavy (commodity industry) then the maintenance capex as % of sales is high.

If the asset turn is 1, then maintenance capex would be roughly 5% of sales. You can compare this % with depreciation as a % of sales to see if both are roughly equal.

You may find some errors in my worksheet and I plan to load an updated version soon. I don’t use these worksheet very frequently now. After using these worksheets for several years, I am now in a position where I can look at the numbers and estimate if the company looks roughly undervalued. A lot of companies don’t pass that test and are rejected outright. If a company passes that filter, I fill up the excel and go through the entire exercise (which is not very precise in itself)

I have loaded a few samples in the google groups. If you go through this exercise yourself several times, you will see patterns and it will be faster for you too.

In addition to the above excel, please have a look at the excel – Quantitative calculation – worksheet : Maintenance capex to see the relationship between Sales, Asset turns, Maintenance capex and ROC.

Ofcourse you can have a counter argument – who the hell wants to go through such an elaborate exercise to value a company? Don’t I have better things to do in life 🙂

I received the following question from sanjay shetty via email. I will try to answer the question and have also simplified it via several assumptions

You mentioned you “use maintenance capex needed to support unit volumes or competitive position (maintenance capex).”
I downloaded your Excel sheets couldn’t figure out the basis for calculation of the same, especially as companies don’t give break ups of maintenance capex. If you could explain would be great.
Maybe my understanding is incorrect, however I feel that all Purchase of Fixed assets should be deducted from Free Cash Flow especially when the amount out there is a yearly spend by the company to grow it’s business.

Let me start with the following definition for free cash flow (paraphrased) as given by warren buffet

Free cash flow = Net earnings + depreciation – maintenance capex

Now you can take the above formulae as a given or debate whether it is correct. I think it is correct as free cash flow is basically discretionary cash which the owners (actually managers on their behalf) of the business can choose whichever way to invest. It is discretionary cash because the business is left with this cash after it has incurred the required capex to maintain its current position in terms of volume and competitive position. If it does not do that, then the business will start degrading and may eventually be wiped out.

Now the discretionary cash can be spent in the following ways

1. Invest in the buiness itself if the returns are good – most common approach. Value adding if the business earns more than cost of capital . for ex: ITC, asian paints, HLL etc. This investment is in fixed assets and working capital
2. Accquire other company – Eg. Marico
3. Return cash to shareholder via dividends or share buyback
4. Just hold cash and do nothing – Ex: Merck, Novartis etc

Now the question – How to calculate maintenance capex? There is no precise formulae for that. The best you can do is to arrive at a rough number as companies don’t give this number. Let take the definition above and let me give my approach

If the maintenance capex is to maintain unit volumes, then value sales would be growing at the rate of inflation. So lets take a hypothetical case (simplified)

Sales = 100
Return on equity = 20% ( debt = 0)
Net margin = 10%
Total asset / sales = 2
Total asset = 50
Depreciation = 5 % of asset

Now in year 2
Sales = 105 (5 % inflation)
ROE = 20%
Net margin = 10%
Total asset / sales = 2
Total asset = 52.5
FCF = 10.5+2.5-2.5 [ asset increase = 2.5 ]

So in the simple case above FCF is equal to Net profit. Ofcourse reality is not so simple. However once you get an idea of the basic concept, you can do a rough estimation of the maintenance capex and free cash flow.

Key point to remember – If the ROE is in excess of 15%, generally the depreciation will covers the maintenance capex and the Net profit will be almost equal to free cash flow.

Exception to the above can be seen in some companies such as Gujarat gas/ HLL etc where the Working capital throws off cash and hence the FCF is actually greater than the free cash flow.

So in response to the question above, I would say that some amount of the Fixed asset has to be adjusted , but I would not deduct all the addition. For ex: A company launches a very profitable product and due to volume growth puts up a new plant. The cash flow may be negative during that year and then become positive a few years later. If you focus on the cash flow based on actual capex, you may undervalue the company when it is investing in a profitable venture and over value a company which is not investing and just milking its assets.

The above post may appear fairly academic and boring, but I think the question asked by sanjay goes to the core of how to value a company.
Next post : I will try to explain how I calculate FCF using the excels I have uploaded