How to Spot a Good Capital Expenditure by a Company?

A company needs to spend money to grow. That is why at the beginning stage of a company, it might have to endure many years of negative cash flow. However, not all spending is created equal. Some capital expenditure might be well spent to ensure that the company is still competitive in the future and yet, some capital expenditure might just be like throwing money into the sea.

As an investor, how can we differentiate the two? Here is a simple way.

Smart Capital Expenditure

The most simple and direct type of smart capital expenditure is when a company is ramping up capacity for a product that has proven to be in high demand. For example, as a bakery sells more bread, the company might be able to observe that its bread is constantly selling out and the current kitchen is unable to keep up with demand. Therefore, it can decide to build a larger kitchen to produce even more bread.

This type of capital expenditure would most likely result in the company increasing its sales in the future.

Dumb Capital Expenditure

However, a company can make dumb capital decisions as well. One example is when a company coughs out money to buy other businesses in an entirely unrelated field. For example, if a company is in the electronics manufacturing sector and its management invests in a healthcare company, then it might be a red flag for investors.

This is because there is no reason for the company to purchase another unrelated company. If an investor wants to invest in the healthcare sector, he can easily just invest in an actual healthcare company. There is no need for the invesstor to invest in an electronic company which invests in a healthcare firm.

In this case, the company should just give the excess cash back to the shareholders as dividends and let them decide how they want to use the money, instead of making the decision for shareholders.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.