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Capital Spending – What Is It and Why Should Investors Care
Broadly speaking, capital spending means money used to increase productive capacity, rather than just to preserve capacity at its present level. By accounting guidelines, to count as a capital outlay, what is built or bought must last over a year; three years is a more normal minimum economic life for capital spending items. The phrase -- and its synonym capital expenditures -- is usually used in the context of business spending, though, as a comparative example, capital spending by all levels of government is also critical to the growth of the economy.
Most businesses operate by managing assets (as well as people), and to grow, they need to increase the value of the assets under management. That statement applies not only to industrial and commercial firms, but also to financial companies that earn asset management fees. “Hard” assets, such as factories, hotels, or mines, have production capacities that cannot be exceeded, except for short periods, which means that to grow, companies must buy or build more of them. Companies can lift their productive capacity by internal capital outlays or by acquiring companies that own the desired assets. While growth through acquisition usually means buying assets at more than book value, acquired companies also come with new product lines and personnel, and that can make the acquisition route a more attractive way to grow than capital spending.
Two opposing factors affect the cost per unit of output of a piece of capital equipment: inflation and technology. While the one raises costs with escalating raw materials and labor prices, the second has the opposite effect. That is seen most strikingly in the cost of data processing capacity, which has fallen by roughly half every two years since the mid-1960s, proving the truth of Gordon Moore’s famous “law”. Thus, service industries, in which data processing capability is quite important, can add capacity at lower cost than heavy industries.
Some industries, such as processing plants, utilities, and airlines, need a lot of hard assets to produce a dollar of revenues; they are called “capital intensive”. Others, such as light manufacturing, need far less. Just imagine the different appearances of a steel mill and a cellphone assembly plant. But not all capital equipment appears on a company’s balance sheet. Airlines and shipping companies often lease their assets for less than the economic lives of the aircraft or ships, which keeps the equipment on the balance sheet of the lessor, rather than the user.
When a firm makes a capital outlay, it places the item acquired on its balance sheet, usually in the property, plant & equipment account, or “capitalizes” it. The company then “depreciates” the asset over its useful economic life. Capital assets have useful lives of up to 40 years (for buildings), and each year, the company reports a depreciation expense equal to a year’s worth of the item’s use; for example, a computer that cost $1,000 and is expected to last five years would generate a depreciation expense of $200 per year. Intellectual property and capital items that are not “hard” assets are also capitalized, but the term “amortization” is used for the annual expense representing the decline in value of an intangible asset with a finite life.
Besides plant, equipment, and residential and non-residential structures, there are many items that can be counted as capital outlays. The cost of painting a building would be included in operating costs, but a new roof, which is expected to last three years or more, would normally be a capital outlay. Beside economic life, whether something is counted as a capital expenditure can depend on how a company uses it. Some of the more unusual expenditures that the IRS or the courts have determined can be treated as capital outlays include, among many others: title abstracts, copyright development, Federal Communications Commission license preparation fees, and settlement of threatened lawsuits. Large things, such as houses, that are bought or built to be resold, however, are treated as inventory and expensed when sold.
While companies need to expand their capital bases to grow, investors do not uniformly reward companies that acquire a lot of capital equipment every year. Just as the market sometimes rewards but often punishes companies that make large acquisitions, it can reward a management for aggressively increasing its capital assets, or it can conclude that management is investing too much in projects with insufficient expected returns. Therefore, investors should actually take a close look at what a company is buying with its capital spending before concluding that a company has above-average prospects.
Investors can track a company’s capital spending on the company’s page in the Value Line Investment Survey by looking at the line entitled “Capital spending per sh” in the statistical array. The figures represent capital expenditures, as found in the company’s statements of cash flows, divided by shares outstanding at the end of the year. In most cases, capital outlays per share vary considerably and do not appear correlated with stock price movements.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.