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How do capital expenditures affect stock returns?

/ 05:16 AM July 25, 2019

The stock market has always treated capital investments of publicly listed companies as a sign of growth.

Because earnings growth comes from expansion, fund managers and analysts use the level of capital expenditures, or capex, to predict a stock’s future profitability.

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The greater the capex budget, the higher the expected value of a stock should be.

Over at the Philippine Stock Exchange (PSE), the annual capex budget of companies has been rising in the last three years from P400 billion plus to over P800 billion this year.

The increase in capital spending in line with a growing economy can indicate that the PSE index could go higher in the long-term.

But how reliable is capex growth as predictor of a stock’s future returns?

Let’s say we define capex growth as the increase in net fixed assets. We then correlate this increase in capex as a percentage of total assets with the corresponding stock returns after one year.

What we will find is that listed companies that undertake high capital investments tend to have lower subsequent stock returns.

This finding is based on the historical performance of PSE index stocks for the past five years.

For example, in 2014, capital investments of large cap companies, which explained stock price changes in about 9.6 percent of the time, were negatively correlated with increase in stock returns.

This means the larger the capital expenditure a company embarks on, the greater the possibility it will have negative stock returns after one year.

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Applying the same model for 2015 historical data, the capex factor, which explained about 5.7 percent of the market’s movement, was negatively correlated with returns.

The same historical negative correlation can also be found in the years to follow.

So why is it that capital expenditures, which are supposed to increase earnings, have tendency to lower stock returns?

Remember that every company has a minimum rate of return that it requires on a every project.

This return, also called the hurdle rate, represents the opportunity cost of the company under the prevailing risk environment.

If a project is risky, a company will require a high internal rate of return, which is the IRR, that can cover its hurdle rate.

It can also be in the form of net present value, also known as the NPV, by making sure that the present value of a project’s cash flows can more than cover its initial investment outlay.

The capex that a company takes on carries certain risks that it may not generate enough returns to meet its hurdle rate.

The risk rises as the size of capex increases, because larger capex requires longer time for a company to recover its investment thereby, raising the uncertainty of realizing a positive NPV or IRR.

As a result, higher risks lower stock returns as the market discounts uncertainties into the share prices.

It is also possible that negative correlation between capex and stock returns may be the result of low market confidence.

For example, if investors perceive management mismanaging the funds of the company by overinvesting its resources, which may not necessarily benefit shareholders, the capital investment may lead to a fall in share prices.

Similarly, investors may not support management judgment in pursuing certain projects. Management may inadvertently undertake negative NPV projects by overestimating its rates of return.

Note that negative NPV projects do not necessarily result to losses. An investment can generate earnings for the company and can, in fact, help grow total earnings.

It is just that the present value of the incremental earnings from the project does not justify the capital investments of the company given its hurdle rate, hence resulting to lower shareholder value.

While capex may indeed increase earnings potential of a company, it is the return on capital investment that we should look out for because only positive NPV capex can sustain a long-term share price appreciation.

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 77th batch of RFP Program this August 2019. To register, e-mail [email protected] or text <name><email> <RFP> at 0917-9689774

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TAGS: capital investments, Henry Ong, Money Matters, Stock Market
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