Why Capital Light Businesses are Superior Compounders
Why Capital Light Businesses are Superior Compounders
<4 min read
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An essential part of the analysis of a business, we need to look at the business model. How the business makes money, what the growth drivers are, and whether or not the business model is asset-light or heavy. An asset-light business has several advantages to a capital-heavy one:
Lower Capital Requirements
Capital-light businesses require significantly lower initial investments compared to their capital-heavy counterparts. These types of businesses hold less risk, as they are not exposed to having high levels of fixed costs and capital requirements to operate and grow the business. Additionally, less capital requirements free up cash for capital allocation initiatives, such as reinvesting into the business, acquisitions, and stock repurchases.
Higher Profit Margins
Due to an efficient cost structure, capital-light businesses boast better margins. Usually, this means focusing its resources on the core business, and out-sourcing segments of the business that is not considered the core. Technology is often leveraged to streamline operations.
Flexibility to seize business opportunities
It is crucial for businesses to have a light business model so that they can adapt to an ever-changing market landscape. New technologies are pushing the pace expected from businesses. Those who are not able to keep up will be left behind. As investors, we want to be invested in companies that can adapt to the changes happening.
Doesn’t need debt to grow and operate the business
By avoiding extensive capital investments, capital-light businesses often carry lower levels of debt and financial leverage. This financial prudence lowers their vulnerability to economic downturns and interest rate fluctuations, offering investors a more stable and secure investment proposition.
Focus on innovation, product development, and customer satisfaction
As capital-light businesses have fewer resources tied up in physical assets, they are able to allocate more capital and attention to R&D, in terms of developing the business model, new business segment, and bettering existing products/services.
Cash-generating machines
Capital-light businesses typically generate robust cash flows due to their streamlined operations and lower fixed costs. Strong cash flow not only supports day-to-day operations but also enables these businesses to reinvest in growth initiatives, reward shareholders through dividends, and pursue strategic acquisitions when appropriate.
Keep in mind: There will be investing opportunities in capital-heavy businesses, some of these have heavy moats, as it requires much capital to compete with these companies. They are, however, often slow growers, or no-growers, that will pay a decent dividend for a while and might be a good investment at the right price. But we are looking for compounders, and capital-light companies are much more likely to give us favorable returns in the long run.
Consider this study from EY looking at asset light, vs. asset-heavy counterparts.
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How to determine if a business is capital-light?
We will use two ratios to determine if a business is capital-light:
Capital Expenditure/Sales should be lower than 10%
Capital Expenditure/Operating Cash Flow should be lower than 20%
Note: The lower these numbers, the better.
Let’s use Fortinet as an example:
First, we find Fortinet’s revenue for 2022 in the Income Statement (Yahoo Finance).
Revenue for 2022 = $4.417 billion
Next we need to find the capital expenditure figure, located in the Cash Flow Statement:
Capital Expenditure for 2022 = $281 million or $0,28 billion
Now that we have both figures, we put them together:
Capex/Sales = 0,28 / 4,4 x 100 = 6.3%
Now let’s look at Fortinet for the next ratio.
Capex / Operating Cash Flow
Here you can find both in the Cash Flow Statement:
Fortinet 2022 operating cash flow = $1.73 billion
Now, let’s put it together:
Capex / OCF = 0.28 / 1.73 x 100 = 16.2%
Fortinet is below our requirement for both sales and operating cash flow, which means it is considered a capital-light business.
Important caveat: Some companies divide “capex” into “growth capex” and “maintenance capex”, while most don’t. If you are able to get a number on how much capital expenditure is used for growth, one can argue that you should exclude this from this calculation. This is because, when we calculate using capex, we are interested in how much cash is needed to maintain the business, not grow it.
Examples of capital-light business models:
Paycom
Fortinet
Admicom
Mastercard
Novo Nordisk
Meta Platforms
Constellation Software
This article is made in cooperations with Stockopedia.
The Invest In Quality team use the platform to:
Research Global Stocks
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Use their stock screener to find hidden global gems
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