1. Estimate and normalize historical net capital expenditures
2. Determine changes in non-cash working capital
3. Calculate firm and equity reinvestment rates
1. Net Capital Expenditures
A company’s statement of cash flows is an excellent source of information for determining historical capital expenditures. Several adjustments, however, must be made to account for its limitations. Since capital spending occurs in chunks, it should be normalized by taking the average over three to five years. Acquisitions and R&D spending should also be categorized as part of capital expenditures. The former must be smoothed out to correct for annual volatility. Net capital expenditures are estimated by subtracting the current period’s depreciation expenses. Depreciation should include impairments, amortization, and the pro forma R&D amortization amount (calculated here). Note that capital expenditures may include other intangible assets.
2. Working Capital
Changes in working capital represent net investments in current assets less current liabilities. Current assets include net receivables, inventories, prepaid expenses, and other current assets. Current liabilities include accounts payable, accrued salaries, deferred revenue, income taxes payable, and other accrued expenses. These amounts can be found on the balance sheet or statement of cash flows. Note that cash and cash equivalents are excluded from current assets and short-term debt (e.g. notes payable and current portion of long-term debt) are excluded from current liabilities.
3. Firm and Equity Reinvestment Rates
Reinvestment rates are primarily used an input to estimating a firm’s expected growth rate (=reinvestment rate * return on capital/equity). The reinvestment rate for operating income is calculated using the equation below. Note that operating lease expenses and R&D spending should be excluded from NOPLAT. (The definition of NOPLAT can be found on the page for ROIC, here).
Firm Reinvestment Rate = (Capital Expenditure – Depreciation + Δ Working Capital) / NOPLAT
The most common method for estimating a firm’s equity reinvestment rate is the retention ratio (=retained earnings / net income). The limitation of this approach is that it assumes a firm reinvests everything that it retains. It also ignores the fact that a firm can issue new equity to fund capital expenditures. A revised measure estimates how much equity a firm actually reinvests into its business. This ratio can be greater than 100% given that firms are not constrained to funding investments solely from net income. Adjustments should be made for R&D expenses and operating leases.
Equity Reinvestment Rate = (Capital Expenditure – Depreciation + Δ Working Capital – Δ Debt) / Net Income
As companies grow and mature, they tend to reduce their net new investment in operating assets. While capital expenditures are likely much greater than depreciation in the initial high growth phase, the difference usually narrows in the transitional phase to stable growth. Industry averages for reinvestment rates may provide good proxies for future rates. It is best to look at the average capital expenditure-to-depreciation ratio for stable firms in the industry. Capital expenditures as a percent of revenues can also be used.
Aswath Damodaran. Estimating Growth. (pp. 24, 30).