How Does CAPEX Affect FCF (Free Cash Flow)
I recently posted a primer on FCF (Free Cash Flow). In that post I discussed why FCF was a superior measure of profitability (compared to NPAT), but I also warned it isn’t a perfect measure. Its virtue is that it better reflects reality by undoing the manipulation of accrual accounting. So, in theory, FCF (Free Cash Flow) should more closely reflect your incremental cash at bank.
While FCF (Free Cash Flow) may be a better measure of cash profitability, it still has shortfalls for the purpose of business valuation. The chief reason is that FCF (Free Cash Flow) is calculated on an ex post basis; it uses historical data. Business valuations, on the other hand, implicitly need to be forward looking. The simple solution is to synthesise FCF (Free Cash Flow) based on forward looking assumptions.
One of the major considerations in synthesizing FCF (Free Cash Flow) is that the result should be reflective of the ongoing earnings of the business; that is, excluding abnormal and one-off items. The beginning profit and working capital figures can be relatively easy to adjust in this respect, but CAPEX (Capital Expenditure) can be more of a red herring. This is because historical CAPEX figures include expenditure on maintain existing assets, expenditure on assets to grow, and expenditure implicit in making business acquisitions. The latter certainly shouldn’t be included in your synthesized FCF (Free Cash Flow) because it isn’t reflective of daily operations.
With this in mind, you need to have a detailed discussion with management regarding the level of CAPEX (Capital Expenditure) that is required for the ongoing operations of the business. This means reversing out CAPEX from acquisitions and making sure you’ve accounted for enough CAPEX to purchase/maintain the assets required for normal operations. Without this, you can’t hope to arrive at a figure that is reflective of the real ongoing earnings of the business.
