What can capital expenditure predictions tell us about our investments?
When analysts issue a capital expenditure forecast for a company, what effect does that have on firm investment?
In new research, Maryland Smith’s Rebecca Hann and Musa Subasi, together with Jin Kyung Choi and Yue Zheng (who are current and former doctoral students at Smith, respectively), closely studied a relatively new analyst research output – capital expenditure forecast, or CAPEX forecast – to see how it influences company investment behavior. The research is forthcoming in the journal Contemporary Accounting Research.
Although CAPEX forecasts are still not considered mainstream, they have become increasingly prevalent over the past decade. These forecasts serve a complementary role to the more ubiquitous earnings per share (EPS) forecasts.
“Think of capital expenditures as large investments on fixed assets. For a company like GM, this might be funding the construction of a large manufacturing plant,” says Hann, an associate professor of accounting and information assurance, KPMG Term Professor and associate dean of doctoral programs at the University of Maryland’s Robert H. Smith School of Business. “So capital expenditure projections are very useful because seeing how much a company plans to invest can tell us about its growth potential.”
CAPEX forecasts convey useful information to investors, Hann says. For example, if analysts revise their CAPEX forecasts for GM from $25 billion to $30 billion, investors are likely to view it as good news.
If the market believes analysts are credible, analyst CAPEX forecasts can play at least two roles.
“If a forecast says a company should invest at a higher level, banks would be more willing to provide loans,” says Subasi, an assistant professor of accounting. This can help firms with limited capital to pursue their positive NPV projects.
CAPEX forecasts can also play a monitoring role. Executives at major companies have incentives to build empires, which means companies sometimes invest in projects that may not be of great value to investors. If GM spends $25 billion while analysts forecast a CAPEX of $20 billion, investors are likely to have questions. That’s when CAPEX forecasts play a disciplinary role, Hann says, because if a company is way over its investment predictions, executives might look to curb their investments.
It’s in these circumstances where the value of CAPEX forecasts lies, adds Subasi. “Having this information can help prevent companies from overinvesting, which benefits the company in the long-run because overinvesting typically leads to performance reductions and monetary losses.”
For decades, investors have turned to EPS forecasts as the No. 1 tool for assessing a company’s valuation. These forecasts, however, do not tell the whole story. And that’s why CAPEX forecasts can be so instructive.
“Analysts with industry expertise are more likely to provide not only EPS forecasts, but also CAPEX forecasts,” Hann says. “We can see that investors react to these forecasts and managers are utilizing them to make more informed investment decisions.”
Read more: “An Empirical Analysis of Analysts’ Capital Expenditure Forecasts: Evidence from Corporate Investment Efficiency” is forthcoming in Contemporary Accounting Research.