Free Cash Flow - Growth Capex?
Sorry on typos, dodgy old phone screen. Moved to PE thread as IB is just kids arguing over tier lists.
My MD keeps insisting the definition of free cash flow is:
‘The amount by which a business’ operating cash flow exceeds its working capital and fixed asset expenditures.’
He then breaks it down saying ‘ basically the cash a business can actually spend on: debt (interest & principal); dividends; M&A; and reinvesting into the business.
my question is: is this statement 100% accurate?
Because if FCF includes (has subtracted) expenditure on fixed assets, this includes both maintaiance AND growth capex. So am I right in saying, that his definition is not exactly true as all leftover (FCF) would have to include growth CapEx (based on his definition?)
Or
Am I just sleep deprived and trying to fixate on his definition too literally.
I do understand growth capex is subtracted as its cash that has already been spent in the year, & thus the real FCF figure is what is then utilised for valuation, debt sculpting, etc...
Appreciate any clarity on this
b
wouldn't growth capex be captured in the 'reinvesting in the business' portion you mention above?
i believe the point here is that fcf in this instance only includes the expenditures that are needed to maintain status quo (i.e., just maintenance capex). as you note, after this, the firm can begin investing into other levers of value creation enabled by the excess fcf generated (growth capex, debt service, etc.)
Yes my point exactly,
Because if you look at the formular for FCF it subtracts CapEx (which is inclusive of both growth & maintenance CapEx) from net income.
FCF = net income + non-cash - ( increase in WC + CapEx)
Thus reducing the free cash flow figure….
However, growth CapEx is money that is ‘reinvested in the business’ so technically the above definition is incorrect.
Your MD is incorrect. Please remind him that Free Cash Flow is equal to Pro Forma Adjusted EBITDA minus Maintenance Capital Expenditures.
Probably the “best” way to think about it is that you should look at FCF as subtracting maintenance but NOT growth capex, so that you can see what the business has to reinvest or distribute to investors. Then you’re able to get a “proper” sense of FCF yield, ROIC, etc… Practically speaking it can be difficult to disaggregate maintenance vs growth capex sometimes, which can lead to FCF being understated.
Thanks for the confirmation.
Very helpful.
only deducting maintenance capex will do.
Is this done by PE firms? Or do they just keep the growth capex in when calculating FCF
In a PE process you'd definitely ask to understand growth vs. maintenance capex as part of diligence, and you'd focus on what the steady state business looks like ex-growth as part of your value triangulation.
Disagree with comments above. If you remove growth capex you’ll need to revise revenue growth projections downwards given less infrastructure in place to support said growth
Yeah, we're not talking about removing it from your DCF. We're talking about current-day FCF to understand the current cash flow generation capabilities of the business.
Agree and separately, for a business that relies on heavy growth capex, you should drive your revenue projections off that growth capex whether it’s new factories that can produce extra widgets or what not. Doesn’t make sense to separate revenue projection from growth capex assumptions. But deducting maint capex gives thr true cash flow distribution or generation ability of the company and show how much the company can reinvest into the business after meeting your contractual cash obligations
Yea, great comment. Thanks.
Assuming in practice this is tough to apply in models?
Q for yourself or wider audience, in practice how is this dealt with in forecasting?
Is this where science meets art?
What is the standard proceedure for dealing with this, both from a sell-side position and then from the perspective of the buy side.
This all really depends quite a bit on the industry. I think you're being a little bit too focused on the nitty gritty, and would benefit from taking a step back. The real question you should be asking when you're forecasting a business' performance is what the underlying growth drivers are, what you physically need to support that growth, and how your forecast captures those dynamics.
So, for example, if you are looking at a highly commoditized manufacturing business, it could be pretty straightforward to say that growth is really just a function of manufacturing capacity (up to some limit of market appetite). In that case, you'd forecast how much you can spend on growth capex, and then you'd take a view on how long it takes for that capex to become operational (do capacity buildouts take 6 months or 3 years?). Then you might say that under normal circumstances, capacity buildouts for this company tend to yield a 20% ROIC, so for every $1 of capex you get $0.20 of margin, once it goes live. Or maybe you have more commodity-specific data, so you say this is adding 1,000 widgets per year of capacity, and then you take a view on the actual commodity price (which in reality you probably would be doing), drive revenue on that, and then layer in all the appropriate costs. Maybe it really is a totally liquid market, or existing customers already have unmet demand, but maybe you need to hire more sales people to sell that extra output. Etcetera etcetera.
On the other hand, maybe it DOESN'T work that way. Maybe your business is actually marketing driven. In that case, "growth" capex might actually be a lagging indicator. Maybe you need to hire 5 more sales people to bring on new customers, and after 3 years, you'll finally have enough customers that you max out your current output. So maybe after 2 years, you need to start building a capacity extension to meet the additional demand from the customers you acquire after year 3.
Or maybe you're a software company, and really there is not much of ANY physical capex you need to do. Growth is just a function of marketing spend, and your cost structure increases are a function of R&D needs to continue improving and maintaining the product, so they're more of an output than an input.
The point I'm trying to make is that there is no one-size-fits-all answer, and you need to actually think about the business on its own terms, and understand if the chicken or the egg comes first in your particular situation.
In my view, the MD is half correct.
I think FREE cash flow is all cash the business spits out that can be deployed outside current operations.
However, I don’t think an investor should give credit for both growth capex cash flow AND growth, afterall you can’t grow without your growth capex.
Thus, I don’t think it’s reasonable to treat growth capex as free even if it could technically be free.
I worked for a partner (group head) that was an absolute psycho about this point. A ton of great input above on how / when / why to include or exclude growth capex. I just want to add that this partner was so jazzed about buying biz with low growth capex or growth capex that we thought we could cut. This was a “software” investor. He ended up filling the portfolio companies with absolute dogshit competitive positioning in their markets AND stopped them from allocating enough growth capex… end result? No carry in the fund. Ton of attrition at portco. Nearly 100% of portcos missed budget each quarter. Hope your partner is better.
I don't really think that's a 'wrong' definition of free cash flow.
There's a reason that free cash flow isn't a GAAP term and when companies report a metric like that they need to include a bridge and a ton of disclaimers. Keep in mind that capex (much less growth/maintenance capex) isn't even a defined term in GAAP.
When people show these measures, they're really just trying to 'tell a story' and make the numbers grokkable for people particularly when GAAP is noisy. So a common exclusion might be acquisitions or maybe the company just built a huge new plant (i.e. growth capex). In either case, if you just looked at the negative flows from 'cash from investing activities', you wouldn't really be painting an accurate picture of the ongoing cash needs.
If you're showing a page in a deck or memo with some model output, just include the line items and it's fine.
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