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Last updated on Jul 25, 2023
Capex, or capital expenditures, are the funds that a company spends on acquiring or upgrading fixed assets, such as buildings, equipment, or software. Capex is an important component of a discounted cash flow (DCF) valuation, which is a method of estimating the present value of a company or a project based on its expected future cash flows. In this article, you will learn how to estimate capex for a DCF valuation using different approaches and sources of information.
Historical average
One way to estimate capex for a DCF valuation is to use the historical average of the company's past capex as a percentage of its revenue or operating income. This approach assumes that the company will maintain a similar level of investment in its fixed assets over the forecast period. To calculate the historical average, you can use the company's financial statements, such as the income statement and the cash flow statement, and divide the capex by the revenue or operating income for each year. Then, you can take the average of these ratios and apply it to the projected revenue or operating income for the forecast period.
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Industry benchmark
Another way to estimate capex for a DCF valuation is to use the industry benchmark of the company's peers or competitors. This approach assumes that the company will follow the industry norms and trends in terms of its capex intensity and growth. To find the industry benchmark, you can use industry reports, databases, or analyst estimates that provide the average or median capex as a percentage of revenue or operating income for the company's industry or sector. Then, you can adjust this ratio for the company's specific characteristics, such as its size, profitability, or growth potential, and apply it to the projected revenue or operating income for the forecast period.
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Depreciation plus growth
A third way to estimate capex for a DCF valuation is to use the depreciation plus growth method. This approach assumes that the company will replace its existing fixed assets at the same rate as their depreciation, and invest additional funds to support its growth. To use this method, you can use the company's financial statements and add the depreciation expense to the projected growth in revenue or operating income for each year. Then, you can multiply this sum by a factor that reflects the company's capex efficiency, which is the ratio of capex to depreciation plus growth. The factor can be based on the historical average, the industry benchmark, or the company's strategic plans.
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Scenario analysis
A fourth way to estimate capex for a DCF valuation is to use scenario analysis. This approach allows you to consider different assumptions and outcomes for the company's capex strategy and performance. For example, you can create a base case, a best case, and a worst case scenario, and assign different capex ratios or factors for each one. Then, you can calculate the capex for each scenario and compare the results. This way, you can capture the uncertainty and variability of the company's capex and its impact on the DCF valuation.
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Sensitivity analysis
A fifth way to estimate capex for a DCF valuation is to use sensitivity analysis. This approach enables you to test how sensitive the DCF valuation is to changes in the capex assumptions or inputs. For example, you can vary the capex ratio or factor by a certain percentage or range, and observe how the DCF valuation changes accordingly. This way, you can identify the key drivers and risks of the company's capex and its effect on the DCF valuation.
Estimating capex for a DCF valuation is not an exact science, but rather a combination of art and logic. You need to use different approaches and sources of information, and apply your judgment and common sense. By doing so, you can create a reasonable and realistic estimate of capex that reflects the company's past performance, future potential, and industry dynamics.
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FAQs
How do you estimate capex for a DCF valuation? ›
One of the simplest and most common methods for forecasting capex is to use the historical capex ratio, which is the percentage of capex to revenue or EBITDA. This method assumes that the company will maintain a similar level of investment relative to its sales or earnings in the future.
Does DCF include CapEx? ›The most detailed approach is to create a separate schedule in the DCF model for each of the major capital assets and then consolidate them into a total schedule. Each capital asset schedule will include several lines: opening balance, CapEx, depreciation, dispositions, and closing balance.
How do you calculate CapEx valuation? ›- Capital expenditures = PP&E (current period) - PP&E (prior period) + depreciation (current period)
- Let's say you own a furniture company and in 2018, you decided to spend money on new equipment and an expanded facility.
Basics of DCF Analysis
2 Free cash flows (FCF) is usually calculated as operating cash flow less capital expenditures (CapEx). Note that the PV has to be divided by the current number of shares outstanding to arrive at a per share valuation.
Capex formula and calculation
Here, Capex refers to capital expenditures, and ΔPP&E refers to the change in the value of property, plant and equipment. Capex can be calculated from a balance sheet or a company's cash flow statement. The formula for a balance sheet and or income statement is the following.
In the DCF method, the cost of equity capital is (properly) identified as the expected rate of return demanded by investors in the regulated firm's common stock. That rate of return is then estimated as the sum of the current dividend yield and a long-term growth rate of dividends per share.
What is the DCF technique of capital budgeting? ›Discounted cash flow (DCF) refers to a valuation method that estimates the value of an investment using its expected future cash flows. DCF analysis attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future.
Do you add CapEx back to DCF? ›Depreciation and Capital Expenditures
It is an expense of Capital Expenditures made in prior years. Therefore, in order to calculate true “Cash flow,” this must be added this back. Similarly, CapEx must be subtracted out, because it does not appear in the Income Statement, but it is an actual Cash expense.
Money spent on CAPEX purchases is not immediately reported on an income statement. Rather, it is treated as an asset on the balance sheet, that is deducted over the course of several years as a depreciation expense, beginning the year following the date on which the item is purchased.
How much should you put away for CapEx? ›Alternatively, some experts recommend setting aside 1% to 2% of your rental property's value each year into a CapEx account. For example, if your rental property is valued at $200,000, you should aim to put away $2,000 to $4,000 annually. This may seem like a lot, but even small expenses can add up over time.
What is the rule of thumb for CapEx? ›
A good rule of thumb when budgeting for investment properties is to set aside 1% to 2% of the purchase price of the home each year for CapEx expenses. This amount should be enough to cover any necessary repairs or renovations as they arise.
Why is CapEx subtracted from FCF? ›CapEx affects FCF because it reduces the amount of cash available to shareholders or creditors. CapEx represents a cash outflow that reduces OCF. Therefore, to calculate FCF, you need to subtract CapEx from OCF.
What makes up CapEx? ›Capital expenditures are a company's major, long-term expenses while operating expenses are a company's day-to-day expenses. Examples of CapEx include physical assets, such as buildings, equipment, machinery, and vehicles.
What should be included in a DCF? ›The seven steps involved in DCF analysis include projecting financial statements, calculating free cash flow to the firm, determining the discount rate, calculating the terminal value, performing present value calculations, making necessary adjustments, and conducting sensitivity analysis.
What is included in DCF? ›The DCF method of valuation involves projecting FCF over the horizon period, calculating the terminal value at the end of that period, and discounting the projected FCFs and terminal value using the discount rate to arrive at the NPV of the total expected cash flows of the business or asset.
How do you project CapEx for a DCF? ›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.