Recall that for the UK’s three listed water suppliers in their latest 12 months, United Utilities (UU.) spent just over 38 per cent of its revenue on its capital account; for Severn Trent (SVT), the ratio was just under 38 per cent; and for Pennon (PNN) it was 27 per cent. These ratios are far above the average for the components of the FTSE 350 index minus both investment trusts and those companies – mostly property firms – that report nil or nominal capex. Similarly, comparing water companies’ capital spending with gross profits, total assets and depreciation plus amortisation all yield similar, although not so excessive, results – the water suppliers are well on the high side. (Click on the link below for spreadsheets of the total data for the FTSE 350.)
Capital spending is often seen as good per se. That’s partly because it offers the prospect of the new and the glitzy, which intuitively appeals to those who fret about the UK’s poor productivity. More importantly, when a company’s bosses fork out for new plant, equipment or whatever they do so to protect what the company already has, to grab market share from rivals or perhaps to build a market from scratch. Whatever their motive, the bosses expect a payback. In practice, capital spending is likely to be divvied up between all those aims, but it is always done in order to capture future profits. In that sense, capital spending is intimately connected to a company’s value – either to preserve it or to enhance it.
|Average for FTSE 350|
|Cap-ex as a percentage of...|
|Depreciation and amortisation||175|
|Sources: S&P Capital IQ & FTSE 350|
We can quantify this connection between capital spending and value in two stages. The first simply acknowledges that the returns from much of a company’s capex must be included in whatever value we might come up with for the company in its current state. So, if the best guess of its future free cash flow is, say, 10p a share a year and that cash flow is capitalised using a required rate of return (or cost of equity) of 5 per cent, then the per-share value is 200p. That figure must include the returns from so-called maintenance capital spending even if we can’t separate it out. Simple – but important to grasp.
What about growth? Now it gets more interesting. For argument’s sake, we can say that any capital spending in excess of what a company charges for depreciation and amortisation is done to generate growth. We can put a value on that excess capex if we think of it as a function of four factors: the percentage return on the excess capex, the cost of the capital used, the rate at which excess returns will fade to the cost of capital and the rate at which future capex is likely to grow.
These factors have two big effects on value. First, the wider the spread between the return on capital and its cost, the greater the value created. In other words, companies that look likely to generate a high return on capital are also likely to generate good value from their capital spending. Second – and less intuitive – value is trimmed by the pace at which excess returns fade to the cost of capital and by the guesstimate for the growth rate in capex.
Take shares in defence services supplier QinetiQ (QQ.), whose capex ratios sit fairly close to the water suppliers yet whose return on equity is sufficient to imply it will create value from future capex, unlike the water suppliers. On the weighted average of its past five years (heaviest weighting on the most recent year), QinetiQ has done 1.7p a share’s worth of excess capex. That might not sound much, but – assuming returns from capex equal the 13 per cent return on equity QinetiQ has averaged over the past five years – then that can justify 42p a share of value. That’s significant in relation to QinetiQ’s 299p share price, especially considering that an annuity valuation of its core profits can produce a figure as high as 275p a share.
Which brings us to the other question raised at the start: what’s the optimum level of capex? Broadly, that depends on the likely return on the capital deployed and the higher that return, the more that capex is justified.
True, that reply leaves unanswered the vital question: how can we estimate the likely return on capital? To that we might add the supplementary question: how can we even calculate a company’s historic return on capital given that its shareholders’ funds are likely to have been a dumping ground for so many inconvenient charges and convenient surpluses?
Still, as a guide, investors must be sceptical where they see companies with low historic returns on capital doing lots of capital spending and encouraged when they see high returns on capital, even when – perhaps especially when – levels of capex are moderate.