The most common way to forecast capital expenditures (CapEx) in a discounted cash flow (DCF) analysis is to get the historical average CapEx as a percentage of revenue and use that to calculate its future value as a function of revenue.
You can also look for management guidance on future capital expenditures, extrapolate CapEx from a depreciation schedule, use a fixed amount every year, or look at industry standards.
Forecasting CapEx is challenging, as no one knows for sure what the future holds. Still, these assumptions are solid and conceivable.
Want to learn more about the logic behind each method? Keep reading.
We’ll start by understanding what are capital expenditures and why they’re important in the DCF model. Then we’ll go into detail about each CapEx forecast assumption.
Ready? Let’s dive in:
What Are Capital Expenditures
A capital expenditure (CapEx) is when a company spends money to acquire, upgrade, and maintain physical assets such as property, plants, buildings, land, technology, or equipment.
Think of it as money a company invests in its infrastructure to improve or expand its operations. For example, to build a new factory, buy new machinery, or upgrade its computer systems.
Most new projects and investments involve capital expenditure.
Capital expenditures are different from operating expenses, which are the day-to-day costs of running a business, such as salaries, rent, and utilities.
How do you calculate CapEx?
CapEx = Change in PP&E + Depreciation Expense
A high level of CapEx indicates a company is investing in growth opportunities, while a low level of CapEx suggests its priority is to preserve its existing assets.
CapEx impacts financial statements in the following way:
- Cash Flow Statement: CapEx appears here directly. It is reported under the investing activities section of the statement. This section shows the cash inflows and outflows from investing in long-term assets, such as PP&E.
- Balance Sheet: CapEx is recorded as a long-term fixed asset, such as property, plant, and equipment (PP&E). The value of the asset is its purchase price, which is depreciated over its useful life.
- Income Statement: CapEx is not reported directly on this financial statement. However, the annual depreciation associated with a capital expenditure is a non-operating expense that reduces net income.
CapEx in The Discounted Cash Flow Model
Discounted cash flow (DCF) is a financial valuation method analysts use to determine the net present value of future cash flows or a project, investment, or a company’s intrinsic value.
As the name suggests, it focuses on actual cash flows entering and leaving the company (free cash flow). Why?
Because cash flows measure a company’s ability to create value and generate revenue.
In contrast, accounting numbers (such as revenue and assets) are subject to accounting rules and assumptions that don’t accurately reflect future potential.
CapEx is a cash outflow.
This is why it has a fundamental role in company valuation and DCF analysis.
Now, evaluating a company involves making predictions for its future financial metrics. And one of those metrics is CapEx.
How to Forecast CapEx in DCF
Discounted cash flow analysis is based on explicit assumptions and future cash flow projections of key items such as operating expenses (OpEx), NOPAT, CapEx, and changes in net working capital.
When it comes to CapEx, it’s hard to predict companies’ future plans for expansion (especially without guidance).
So, how do you forecast CapEx in financial modeling? The five main options are:
#1) As a Function of Revenue
This is the most common assumption used to forecast capital expenditures.
Although it is a simple assumption, that doesn’t mean it’s less conceivable.
Some financial analysts run away from simple stuff because they seem too good to be true. They suspect that if it’s too easy, they’re missing something.
The result is they complicate things for the sake of it.
But the truth is…
CapEx as a function of sales is a perfectly conceivable assumption. Why?
Companies need capital expenditures to support growth. An increase in sales means the company needs more employees and equipment to fulfill the delivery of the products or services it sells.
This may include buying more machines, spaces, technology, land, vehicles, furniture, buildings, etc. to increase production capacity, and achieve the sales target.
Now, here’s how to calculate CapEx under this assumption.
You’ll need financial data of the company you’re analyzing from past years (generally 3-10 years).
More specifically, you divide CapEx by revenue each year. This will give you a percentage.
Then, look for trends in that number.
Does it grow every year? If so you can assume it will continue to grow year after year by using a moving average.
You’re basically reviewing past capital expenditures and estimating future spending based on patterns.
If the percentage of CapEx as a function of sales stays constant, make your forecasts constant too.
Now, one caveat:
CapEx will be dependent on your forecast assumptions for revenue growth. So, you need to already have sales projections before using this method.
#2) Follow Management Guidance
Another way to do a capital expenditure forecast is to simply follow the guidance the company provides.
In some cases, the company’s management team might have a detailed program for capital investments, and they’re willing to share it with investors.
If you listen closely to earnings calls, the CFO will usually give some sort of guidance as to plans for expansion.
You can use this to improve your forecasts.
For example, when I was researching Jerónimo Martins for the CFA Institute Research Challenge, I listened to earnings calls and paid close attention to the part where analysts get to ask the CFO questions. Ana Luísa Virgínia revealed plenty of good information:
- The number of planned new store openings for each geography the company operates in for the following years.
- The cost of opening a new store (and that a store remodeling costs around the same as a new store opening).
- And the ratio of rented to bought stores.
Thus, our team modeled our DCF CapEx forecasts after this guidance.
You can also take into account forecasts for economic indicators of the countries in which the company operates.
Is the population aging? Is that good or bad for the industry? Is it an emerging economy with lots of potential, or a mature stable economy?
What are the inflation forecasts by the IMF (International Monetary Fund)? More inflation will result in significantly higher CapEx costs, as construction is among the most impacted sectors.
Read also: How Inflation Affects Asset Depreciation
Lastly, you can also break down the forecast into individual projects and estimate the cost of each project.
All these assumptions make sense and are justifiable, and that’s what matters most. Why? Because no one knows for sure with 100% certainty—not even the company—what will happen in the future.
#3) Use a Depreciation Schedule
As assets (PP&E) are used, they degrade and lose value. Depreciations quantify how much value an asset loses.
A depreciation schedule shows the yearly depreciation expense of an asset over its useful life.
Let’s say a company buys a machine for $100,000 with an estimated useful life of 10 years. Using the straight line method (with a salvage value of $0), the depreciation schedule would show that the depreciation is $10,000 every year.
Now, how does this help you forecast CapEx?
If the company publishes information on a depreciation schedule for future years, you can look for patterns and assume those for the future.
You can also—similarly to method #1)—set the depreciation expense as a percentage of revenue and calculate the implicit CapEx accordingly.
For example, if depreciations increase and the company uses the straight line method, it means the company has more assets, therefore it invested more money into capital expenditures.
Once again, you’ll need to already have revenue forecasts in order to do this.
Between using depreciation divided by revenue or CapEx divided by revenue, you should look at the historical years.
Which method gives you a more stable percentage over the years? Which one shows a clearer trend? That’s the best method for CapEx forecasting out of the two.
#4) Assume a Fixed Amount
You can also set a fixed amount for capital expenditures every year.
When is this appropriate?
When valuing the enterprise value of mature companies already dominant in the market in which they operate, and past their fast-growing early days.
If a company becomes big enough, it can even face monopoly regulations if it grows any larger.
Thus, they focus more on preserving market share, as opposed to increasing it.
In these cases, you can use a fixed number for the CapEx projection—the average historical absolute value of CapEx in the balance sheet.
#5) Look at Industry Benchmarks
Lastly, you can use industry standards to forecast capital expenditures.
This involves examining industry peers you consider comparable to the business you’re evaluating.
You will typically construct a peer group of 3-10 companies based on the similarity of operations (value proposition, size, and geography) and financial health.
Next, you can look at, for example, the ratio between total cash flow from operations (in the cash flow statement) and CapEx for each company in the peer group. What’s the average? Any outliers? Any tendencies? Consider these for your forecasts.
It is appropriate to use industry benchmarks for forecasting capital expenditures when:
- The company operates in an established industry with clearly defined norms for capital expenditures.
- The business’ has similar spending patterns to its peers.
- There is adequate data available on industry spending patterns.
You shouldn’t use industry benchmarks for CapEx forecasting when:
- The company operates in a unique or emerging industry. An example of this is the commercial space industry.
- Its business model or growth trajectory is significantly different than its peers.
- There is limited or unreliable data available on industry spending trends, making it difficult to make accurate comparisons and reliable forecasts.
How to Forecast Capital Expenditures: The Bottom Line
Defining CapEx for an explicit forecast period to get a fair value in a DCF valuation can be difficult.
The truth is, no one can predict things with 100% accuracy, not even the highest-earning investment banking analysts. It’s easy to spiral down into calculations that are too detailed for the purpose at hand.
The best you can do is understand the industry and the company you’re dealing with.
Use a reasonable growth rate. And the more points you have to support your choice of assumptions the better. It’s easy to perform calculations. Getting to the right conclusions is the hard part.
Questions? Thoughts? Feedback? Let me know in the comments below.
