Updated: May 5
Today's post is by Hanna Murina, a PhD student at Kyiv National Economic University, Ukraine. Hanna is a finance professional with a diverse background spanning investment banking, corporate finance, commercial banking, financial sector regulation and financial consulting. Her well-rounded education includes degrees from the Ukrainian Banking Academy, Northumbria University, NaUKMA, and EERC, as well as ongoing PhD studies at Kyiv National Economic University. Hanna earned her CFA charter in 2008, demonstrating her commitment to excellence in the field. Her interest in business valuation, which emerged during her early years at an M&A boutique, has since evolved into a focus on developing sustainable CAPEX proposal to refine terminal value estimation.
DCF valuation is the most commonly used method in fundamental value analysis. It involves discounting cash flows of an explicit forecast period (forecast horizon) and a terminal value. The latter is expected to represent cash flow results in perpetuity beyond the forecast horizon. This note focuses on estimating CAPEX as a component of the sustainable cash flow for terminal value estimation.
There is a widely used rule of thumb in corporate finance which prescribes that long-term sustainable CAPEX should equal the depreciation charge. This rule can be found in valuation textbooks and manuals, but it can significantly mislead valuation results. The rule lacks a reasoned basis and has never been proven to be correct. It is a popular simplification that overlooks critical factors such as inflation, real growth, technological progress, and irregularities in fixed asset replacement. By disregarding these factors, there is an increased risk of overestimating total value by not counting for the impact of inflation and real growth, underestimating total value by not counting for the impact of technological progress, and misestimating the total value due to irregularities in CAPEX. Depending on the depreciation level of the assets, irregularities may lead to underestimation or overestimation.
Positive inflation and real growth lead to sustainable CAPEX being higher than the depreciation charge. This is because CAPEX occurs at current prices, while depreciation reflects historical, mostly lower, prices of past periods. The assumption of positive real growth in perpetuity requires forward-looking CAPEX that includes future needs in capacity growth. Technological progress can be considered as a percentage change in the amount of fixed assets per unit of capacity. Efficiency boost from technological progress implies that the same level of output can be reached with fewer fixed assets, therefore, technological progress is associated with a negative percentage change in fixed assets.
CAPEX irregularity is another possible contributor to the inaccuracy of the rule of thumb.
For businesses with a pool of relatively unconcentrated fixed assets with relatively short useful lives, CAPEX tends to be smooth from year to year. However, for businesses that have concentrated fixed assets with restricted possibility for partial replacements CAPEX is likely to be irregular. Accounting for CAPEX irregularity (lumpiness) can be a challenging task in a DCF model. In such cases, sustainable CAPEX should count for cumulative inflation of the entire previous useful life, cumulative real growth for the entire next useful life, and the time value of money of the lumpy cash flow that may occur in the near future for highly depreciated assets (above 50%) or in the distant future for new assets with a low depreciation level (below 50%).
For illustrative purpose let us assume that a hypothetical scenario where a business has half of its fixed assets with relatively smooth CAPEX and the other half consisting of highly concentrated long-lived assets with irregular CAPEX. The first CAPEX is repeated from year to year with an annual adjustment for inflation rate (i) and rate of technological progress (y) of the most recent past period and for real growth rate (g^r) for the next annual period. Assuming CAPEX at the end of each year, then the estimation can be expressed with formula (1).
Estimating the sustainable CAPEX for the irregular half of fixed assets requires a granular data for each fixed asset or grouped assets by useful life and depreciation level. Such granularity is required for the normalisation formula* that produces an estimate of sustainable CAPEX taking into account all the factors mentioned above. In cases where a reasoned assumption about technological progress in perpetuity is made, the inflation rate for fixed assets can be replaced with a rate of price change per unit of capacity (i^c) that incorporates both inflation and technological progress according to formula (2). However, this level of granularity required for accurate value estimation can be a restrictive condition since such information is normally not available in public financial disclosures, putting external investors at a disadvantage.
In most real-life situations, the alternatives described above produce a ratio of CAPEX to depreciation charge above the offered by the rule of thumb ratio of 1.0. Only in cases of irregular CAPEX with a low depreciation level (i.e., fresh assets with distant next lumpy CAPEX), the ratio may fall below 1.0. This occurs when the impact of time value of money outweighs inflation and real growth factors. Although technological progress can effectively decrease the ratio; it is a more theoretical concept in the context if its feasibility in perpetuity.
The rule of thumb has been widely used for decades without proper verification. Nowadays, there is a better understanding of its inherent inaccuracy, and there are tools available to improve terminal value estimation. Particularly, these improvements may increase trust and valuation accuracy for businesses with concentrated fixed assets such as SME, real estate, infrastructure, green energy. Another interesting insight arises for businesses with different average depreciation levels, where a lower sustainable CAPEX is associated with a lower depreciation level, given all else being equal, including the depreciation charge.
* Murina H. (2023) Business valuation with irregular capital expenditure, The European Business Valuation Magazine, Page 4-14, Volume 2 Issue 1