Buffett: Depreciation Is A Proxy For Required Capital Expenditures

(May 4, 1998) Warren Buffett says that the depreciation is a proxy for required capital expenditures. That’s why Mr. Buffett does not ignore the depreciation in calculating the earning power of a business. In addition, a great business is typically capital light business such that they need minimal amount of capital to expand into new market.

required capital expenditures

Buffett: Depreciation Is A Proxy For Required Capital Expenditures

Get The Full Series in PDF

Get the entire 10-part series on Charlie Munger in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Q1 hedge fund letters, conference, scoops etc

Transcript

My question has to do with why you mentioned earlier about how companies have to reinvest a certain amount of cash in their business every year just to stay in place. And one could say that the best businesses are the ones that not only throw off lots of cash but can reinvested in more capacity. But I suppose the paradox is that the better companies opportunities for making expansionary capital expenditures the worse they appear to be as consumers of cash rather than generators of cash. What specific techniques have you used to figure out the maintenance capital expenditures that you need to do in order to figure out how much a cash. How much cash the company is throwing off. What techniques have you used on Gillette or other companies that you've studied.

Well if you if you look at a company such as Gillette or Kroger you won't find great differences between their depreciation forgot about amortization for them all the depreciation and sort of the required capital expenditures that if we got into this hyperinflationary period or I mean you can find you can set up cases where that wouldn't be true. But by and large the depreciation charge is not inappropriate in most companies to use as as a proxy for required capital expenditures which is why we think that reported earnings plus amortization of intangibles usually gives a pretty good indication of of of earning power. And I don't I I've never given a thought to whether Gillette needs to spend 100 hundred million dollars more a hundred million dollars less than depreciation in order to maintain its competitive position. But I would guess it's the range is even considerably less than that versus its it's recorded depreciation the business as you have to worry about. I mean I'm an airline business is a good case and in the end airlines you know you just have to keep spending money like crazy and you have to spend money like crazy if it's attractive to spend money and you have to spend it the same way if it's unattractive. You just. It's part of the game. Even in our textile business to stay competitive we would have needed to spend substantial money without any necessary any any clear prospects of making any money when we got through spending it. And those are real traps those kind of businesses and they may work out one way or another but but they're dangerous and in a See's Candy we would love to be able to spend 10 million one hundred million five hundred million dollars and get anything like the returns we've gotten in the past.

But there aren't good ways to do it unfortunately. We'll keep looking but it's not a business where capital produces the profits flight safety capital produces the profits that you need more simulators as you go along and more pilots are to be trained and so capital is required to produce profits. But it's just not the case it seems and at Coca-Cola particularly when new markets come along you know the Chinas of the world or East Germany or something of the sort the Coca-Cola company itself would frequently make the investments needed to build up the bottling infrastructure to rapidly capitalize on those markets. The old Soviet Union. So those are those are expenditure you don't you make the calculation out and you just know you've got to do it you've got a wonderful business and you want to have it spread worldwide and you want to capitalize on it to its fullest and you can you can make a return on investment calculation. But as far as I'm concerned it's a waste of time because you're gonna do it anyway and you know you want to dominate those markets over time and eventually you'll probably fold those investments and other bottling systems as them market gets the dollar but you don't want to wait for conventional bottlers to do it. You want to be there. One of the ironies incidentally might get a kick out of us on the older members of the audience that when the Berlin Wall went down and Coke was there that day with with Coca-Cola for East Germany that Coke came from the bottling plant at Dunkirk. So there was a certain poetic. Irony there.

Charlie do you have a Hammond I've heard Warren say since very early in his life that the difference between good business and a bad business is usually a good business just throws up one easy decision after another whereas the bad this business gives you a horrible choice where the decision is hard to make. Is this really going to work. Is it worth the money.

If you want a system for determining which is a good business and which is a bad business to see which one is throwing the management bloopers. Time after time after time. Easy decisions was not very hard for us to decide to open a new seed store in a new shopping center in California. That's obviously going to succeed. It's a blooper on the other hand there are plenty of businesses where the decisions that come across your desk are just awful. Those businesses by and large don't work very well.

I've been on the board of Coke now for 10 years and we've had project after project come up and there's always in our ally. But it doesn't really make much difference to me because in the end almost any decision you make that solidifies and extends the dominance of coke around the world in an industry that's growing by a significant percentage and which has great inherent underlying profitability.

The decisions are going to be right and you've got people that will execute them well.

Here's what you get blooper after blue now and then Charlie and I sat on U.S. air and the decisions would come along and it would be a question of do you know do you buy the Eastern shuttle or whatever it may be.

And you're running out of money and yet to play the game and to keep the traffic flows such as for connecting passengers you just have to continually make these decisions where you spend a hundred million dollars more on some airport and their agony because again you don't have any real choice but you also don't have any real conviction that it's going to translate that those choices are going to or lack of choices to translate themselves into real money later on. So one game is just forcing you to push more money into the table with no idea what kind of a hand you hold and the other one you get a chance to push more money and knowing that you've got the winning hand all the way drawing the why we buy U.S. Air. Could have bought more coke.




About the Author

Jacob Wolinsky
Jacob Wolinsky is the founder of ValueWalk.com, a popular value investing and hedge fund focused investment website. Prior to ValueWalk, Jacob was VP of Business Development at SumZero. Prior to SumZero, Jacob worked as an equity analyst first at a micro-cap focused private equity firm, followed by a stint at a smid cap focused research shop. Jacob lives with his wife and four kids in Passaic NJ. - Email: jacob(at)valuewalk.com - Twitter username: JacobWolinsky - Full Disclosure: I do not purchase any equities anymore to avoid even the appearance of a conflict of interest and because at times I may receive grey areas of insider information. I have a few existing holdings from years ago, but I have sold off most of the equities and now only purchase mutual funds and some ETFs. I also own a few grams of Gold and Silver