Incremental investment in fixed capital is another important value driver in an analysis of shareholder value. This session focuses on where to find the data, how to calculate historical fixed capital trends and how to project future fixed capital needs. As with previous sessions, we will use Gateway, Inc., as of April 21, 2000, as a case study. Readers who want to calculate incremental fixed capital while reading this tutorial may wish to download the accompanying spreadsheet.
What Does "Incremental Fixed Capital" Mean?
To understand what we mean by "incremental fixed capital," let's break this phrase down into its component parts:
- Incremental. This means that we want to look at the additional cash a company annually invests in its long term operating assets.
- Fixed. This means we look at cash tied up in long term operating assets such as Plant, Property and Equipment (PP&E) and Capitalized Leases.
- Capital. This means that we want to calculate the amount of cash that a company has to tie up annually in incremental fixed capital in order to run its business.
For industrial companies, then, "incremental fixed capital" equals the cash a company invests annually in long term operating assets.
We can calculate a company's annual investment in fixed capital by analyzing its Cash Flow Statement. To calculate a company's gross fixed capital investments, we sum the following items:
- Capital expenditures
- Capitalized software costs
- Other investment activities, net
- Acquisitions, net of cash acquired
However, before we finish, we need to deduct annual Depreciation and Amortization (found on the Cash Flow Statement in the "Cash Flow from Operating Activities" section). This is because we want to calculate cash invested over and above a company's annual depreciation. Intuitively, this makes sense because when capital expenditures equals depreciation, a company is roughly maintaining its long term physical assets. In other words, we consider only capital investments above and beyond depreciation as "incremental" investments.
Case Study: Gateway, Inc., as of April 21, 2000
The following table summarizes calculations for Gateway:
|
1994 |
1995 |
1996 |
1997 |
1998 |
1999 |
| Capital expenditures |
(29.0) |
(77.5) |
(86.0) |
|
|
|
| Software costs |
(26.6) |
(39.0) |
(31.6) |
|
|
|
| Total capital expenditures |
(55.6) |
(116.6) |
(117.5) |
(175.7) |
(235.4) |
(338.2) |
| Other investing activities, net |
|
(13.2) |
2.7 |
(4.1) |
(1.0) |
(1.4) |
| Acquisitions, net of cash acquired |
|
(3.6) |
|
(142.3) |
|
|
| Total Gross Fixed Capital Investments |
(55.6) |
(133.3) |
(114.9) |
(322.0) |
(236.4) |
(339.6) |
| Depreciation and amortization |
18.0 |
38.1 |
61.8 |
86.8 |
105.5 |
134.1 |
| Incremental Fixed Capital Investments |
(37.6) |
(95.3) |
(53.1) |
(235.3) |
(130.8) |
(205.5) |
Source: Gateway's Cash Flow Statements used for this table can be found here: 1996 and1999.
Note: This data should be entered into the "Inputs" worksheet of the "Fixed Capital.xls" spreadsheet.
Building on this metric, we can calculate how much incremental fixed capital Gateway must invest to generate a dollar of new sales:
|
1995 |
1996 |
1997 |
1998 |
1999 |
| Incremental Fixed Capital Investments |
(95.3) |
(53.1) |
(235.3) |
(128.8) |
(205.5) |
| Sales |
3,676.3 |
5,035.2 |
6,293.7 |
7,467.9 |
8,645.6 |
| Incremental Sales |
975.1 |
1,358.9 |
1,258.5 |
1,174.2 |
1,177.6 |
| Incremental Fixed Capital Investment Rate |
9.8% |
3.9% |
18.7% |
11.0% |
17.4% |
Over this five year period, then, Gateway invested $718 million into its fixed capital in order to generate $5.9 billion in incremental sales. In other words, Gateway invested 12.1% of incremental sales into fixed capital.
In the Price-Implied Expectations (PIE) analysis we perform in the book, we assume that Gateway will invest slightly under this amount at 11.0% of incremental sales (see page 97).
Sidebar: Amortization of Goodwill
In our calculation of Net Fixed Capital Investments, we calculate the investment in fixed capital over and above depreciation. However, many companies lump depreciation and amortization together in one line on the cash flow statement, making it impossible to only subtract depreciation from Gross Fixed Capital Investments.
Thus, for companies with significant amortization of goodwill, you may wish reverse expenses associated with annual goodwill amortization (associated with mergers and acquisitions). For example, you can infer this expense in 1999--buried in the SG&A line--by looking at the relevant table in Gateway's 1999 10-K:
|
1998 |
1999 |
| Accumulated amortization of intangibles ($, MM) |
$ (25.3) |
$ (38.9) |
Using these two numbers, you can infer that Gateway expensed the difference between these two amounts, or $13.6 million, in goodwill amortization in 1999. We subtract this amount from "Depreciation and Amortization" of $134.1 million to infer "Depreciation" alone equals $120.5 million. For simplicity's sake--and because this adjustment is not significantly material--we did not make this adjustment in the main body of the tutorial above or in the text.
