Investment in fixed capital, also known as capital expenditures (capex), is an important component in evaluating a company’s free cash flow. Proper calculation of fixed capital investment is crucial for discounted cash flow (DCF) valuation models like FCFF and FCFE. This article will explain the key methods to calculate fixed capital investment, including dealing with asset sales, as well as its impact on free cash flow valuation. By understanding fixed capital investment, investors can better estimate a company’s intrinsic value and make informed investment decisions.
Two main methods to calculate fixed capital investment
There are two main methods to calculate fixed capital investment (FCInv):
1. When there are no asset sales:
FCInv = Capital expenditures = Ending PPE – Beginning PPE + Depreciation
Here fixed capital investment equals the capital expenditures amount spent to buy new assets.
2. When there are asset sales:
FCInv = Capital expenditures – Proceeds from asset sales
Capital expenditures can be found in the cash flow statement. Proceeds from asset sales is the cash inflow from selling assets, also found on the cash flow statement.
If there is insufficient info in the financial statements, an alternative is:
FCInv = Ending PPE – Beginning PPE + Depreciation – Gains on sale
Gains on sale of the disposed assets can be found on the income statement.
Why fixed capital investment impacts free cash flow
Fixed capital investment represents the cash outflow spent by a company to invest in new property, plant and equipment (PP&E) needed for operations. This capital expenditure does not impact net income, but it reduces cash available to the firm.
As a result, fixed capital investment is deducted when calculating free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). These are key valuation metrics to find intrinsic value using discounted cash flow models.
For example in the FCFF formula:
FCFF = Net Income + D&A – Change in Working Capital – Fixed Capital Investment
The higher the fixed capital investment, the lower the FCFF. This directly lowers the DCF valuation of the firm.
Likewise, fixed capital investment is deducted when calculating FCFE as well. Properly estimating a company’s fixed capital investment needs is essential for coming up with an accurate intrinsic value.
Fixed capital investment reveals capital reinvestment needs
A company’s fixed capital investment also reveals how much capital needs to be reinvested into the business to support operations and growth.
Analyzing the historical fixed capital investment needs and growth rates provides clues into future capital reinvestment needs. This helps investors determine the stable growth rate to use in DCF terminal value calculations.
For example, a company that requires heavy fixed capital investment to grow may have limited potential to keep growing at a high rate for the long term. However, a company with lower reinvestment needs may have more room to grow at above average rates for longer.
Assessing fixed capital investment trends over time rather than just relying on the most recent year provides a more complete perspective. Understanding fixed capital investment provides key insights into the future cash generation potential of a business.
Fixed capital investment analysis enhances DCF models
In summary, carefully analyzing fixed capital investment improves discounted cash flow valuation models like FCFF and FCFE. Investors should pay close attention to:
– The method used to calculate fixed capital investment, properly accounting for asset sales
– How fixed capital investment directly reduces free cash flow available to investors
– What the level and growth of fixed capital investment reveals about future capital reinvestment needs and growth potential
Taking the time to research and forecast fixed capital investment leads to more accurate intrinsic value estimates from DCF models. DCF models provide the core valuation methodology for many fundamental investors. Overall, understanding fixed capital investment analysis enhances equity research and valuation capabilities.
Properly estimating fixed capital investment is crucial for discounted cash flow models that are widely used in fundamental equity analysis. There are two main methods to calculate it, handling scenarios with and without asset sales. Fixed capital investment represents cash outflows so it directly reduces free cash flow valuation metrics like FCFF and FCFE. The trends in fixed capital investment also provide insights into future capital reinvestment needs and growth potential for a business. Implementing detailed fixed capital investment analysis improves DCF models and ultimately leads to better informed investment decisions.