Production assets

As mentioned earlier (see the chapter "The concept of valuation"), to conduct business (manufacture a product or provide a service), the company, among other things, uses material assets (or capital assets), which are denoted on the balance sheet as "Property, plant and equipment". In our analysis we determine which capital assets are actually used in production and call them "production assets" or "production base".

For the purposes of valuation, we calculate average monetary value of production assets historically needed for generation of a unit of revenue. This number is used to calculate the amount of capital expenditure (CAPEX) needed to support increased revenue - that is if we forecast it to increase. We call this expenditure "new CAPEX".

At the same time, we need to calculate the amount of capital expenditure needed to maintain the existing production assets that support the current level of production - we call it "maintenance and replacement CAPEX". This expenditure is best estimated (though not always accurately) by the current amount of amortization, depreciation and depletion - another line from the company's financials (this time the cash flow statement).

There is a constraint, however, on how much a company could spend on CAPEX. This constraint is of a financial nature: the CAPEX should not exceed the sum of the amount of cash generated by the company's operations and the maximum amount of debt increase and equity issuance (sale of shares to investors) the company can afford in any given year without jeopardizing its financial standing.

There are a number of financial ratios closely monitored by the company itself and its lenders that are used to gage the company's financial health. In combination with historical data for other companies in a particular industry, these ratios are also used is estimating a probability of the company defaulting on its obligations to pay its debt. Usually a company operates within very well defined ranges for key financial ratios which limit its ability to borrow.

Returning back to our valuation model: if the company hits the "ceiling" we set for it on how much outside new financing it could safely obtain, we limit the revenue growth by the number that can be supported by production assets corresponding to the maximum amount of CAPEX (both new and maintenance/replacement) the company can afford.