The Long Term Relationships between Capital Expenditures and Depreciation Across Industries: Important Data for Capitalized Income Based Valuations

Abstract

Introduction A better understanding of the long-term relationship between capital expenditures (capx) and depreciation will help financial analysts better forecast the long term cash flows used to estimate company values when capitalizing income. Earlier theoretical studies have shown that, when using the Gordon Growth model, assuming capx = depreciation results in an over valuation.1 This upward bias also affects valuations using the DCF model when the Gordon model is used for terminal value. This article provides long-term empirical evidence regarding the relationship between capx and depreciation over the 1986-2001 time period for 582 companies across 39 industries. During this period, on average, capx exceeded depreciation by 21%, though the amount varied across industries. The data presented in this article provide important information to those using the capitalized income approach employing the Gordon Growth model because they reflect the actual long-term relationships between capx and depreciation. Business appraisers and financial analysts should consider the empirical capx/depreciation relationship when making assumptions for use in this growing perpetuity model. The Gordon Growth model is commonly used for valuation in both the capitalized income approach and for the terminal value in the discounted cash flow (DCF) approach to valuation. This model assumes that a company will experience a constant growth of cash flow into perpetuity: