I was at a private equity event the other day, and they were talking about differentiating between growth capex versus sustaining capex for the purpose of a business valuation. How can I determine this for my business?
The simple answer is: with great difficulty.
I began giving business valuation opinions in 1969, about 45 years ago, and I can tell you that up until about 25 years ago, I can’t remember dealing with a business owner who, when I talked to them about sustaining capital reinvestment and growth capital, knew what I was talking about. Most business owners, and professionals - including business valuators - didn’t draw that distinction.
That said, in my experience most business owners know enormous amounts about their businesses, and really meaningful and useful information can be drawn out of them if good questions are asked by people they respect. I have found that to be particularly true where owners are told upfront why the questions are being asked, and why they aren’t a waste of time.
In early days, many of the business owners I dealt with would ask when I started questioning them about sustaining capital versus growth capex: "What’s that?", then "What's the relevance of the difference?" and "I don't want to waste time talking about it." However by the time the sessions were finished - because there almost always was more than one session about the difference between sustaining capital and growth capex because it's a really difficult area - many of them, including a number who owned very large businesses would say something along the following lines: "Look, this has been hugely educational for me. It’s going to enable me to operate my business better than I have been because I am going to be thinking about the capex split in the decisions I make."
Now, having said that, sometimes particularly in capital intensive businesses and particularly I would say after 1995, maybe after 1990, as technology has changed and has evolved so quickly the question of sustaining capital versus growth capital becomes ever more important. This is because there are circumstances where a capital intensive business in the current environment may have to spend a great deal more sustaining capital today in order to remain competitive than it would have had to do twenty years ago.
In some instances it is necessary to engage equipment experts to learn what's happening in a given industry, in a given business, what the expectation is in terms of technological change, and what their sustaining capital might have to be over the next five, 10, 15 years. Not equipment appraisers, but people who advise people on equipment from a technology and changing technology point of view.
I think the question of sustaining capex versus growth capex split is likely to become increasingly important as technological change continues to evolve. The more change of that nature, the more capital that needs to spend on sustaining, the less value there is going to be in the business where business value by definition is a present value of all future expectations. Hence in turn the more difficult and subjective some notional business valuations may become.