CAPEX to Depreciation Ratio: A Financial Modeling Guide

The CAPEX-to-depreciation ratio is one of the most revealing inputs in a financial model and one of the most commonly mishandled. A company that consistently spends less on CAPEX than it depreciates is effectively liquidating its asset base. A company spending 3× depreciation is investing aggressively in growth. Getting this ratio right is essential for accurate free cash flow forecasting and meaningful valuation. This guide explains the rules, benchmarks, and common errors in financial modeling.

Why CAPEX and Depreciation Matter in Financial Modeling?

In a discounted cash flow model, free cash flow (FCF) is typically defined as EBIT(1−t) + Depreciation − CAPEX − ΔWorking Capital. This means CAPEX directly reduces FCF, while depreciation adds it back. The CAPEX-depreciation spread, therefore, has a direct and significant impact on every FCF projection and on the model’s terminal value.

Most analysts understand this mechanically. Fewer understand the economic logic: depreciation is an accounting charge representing the use up of existing productive capacity. CAPEX is the cash invested to maintain or expand that capacity. In equilibrium, a company that does nothing but maintain its existing business should spend CAPEX approximately equal to depreciation. But inflation, replacement cost escalation, and the ongoing need to update technology mean that even a “maintenance-only” company typically needs to spend more than depreciation to keep its asset base intact.

Dr. Andrew Stotz’s research across thousands of companies using the ValueModel framework identifies a reliable benchmark: in a steady-state business, CAPEX should equal approximately 150% of depreciation. This accounts for both maintenance requirements and modest asset base growth. Deviating significantly below this benchmark signals either under-investment (which eventually harms competitiveness) or an asset-light business model that justifies a lower ratio.

What Is the CAPEX-to-Depreciation Ratio?

The CAPEX-to-depreciation ratio measures how much a company is investing relative to the rate at which its existing assets are being consumed. Formula:

CAPEX / Depreciation Ratio = Capital Expenditures / Depreciation & Amortisation

Interpretation:

• Ratio < 1.0x: Company is spending less on new assets than its existing assets are depreciating. Asset base is shrinking in real terms. Acceptable short-term (e.g., downturn conservatism) but unsustainable long-term.
• Ratio = 1.0x: Replacement-only CAPEX. The company is maintaining but not growing its asset base. Suitable for low-growth or declining businesses.
• Ratio 1.2–1.5x: Steady-state investment. Typical of mature companies maintaining a competitive position and modest growth.
• Ratio > 2.0x: Heavy investment phase. Typical of companies building new capacity, entering new markets, or operating in high-growth industries.

When building or reviewing a DCF model, check this ratio explicitly in every projection year. If your model shows CAPEX falling below depreciation in the terminal year, you have likely created an unrealistically optimistic long-run FCF.

Maintenance CAPEX vs. Growth CAPEX

CAPEX consists of two economically distinct components that financial models should treat separately:

Maintenance CAPEX

The investment required to keep existing assets productive and competitive. Think: replacing worn-out machinery, refurbishing retail stores, upgrading servers. Maintenance CAPEX preserves revenue-generating capacity; it does not create new capacity. As a first approximation, maintenance CAPEX ≈ depreciation, though inflation and technology change mean replacement cost often exceeds book depreciation.

Growth CAPEX

The investment above maintenance is for funds capacity expansion and new revenue streams. Building a new factory, acquiring a competitor’s equipment, opening new stores, these are growth CAPEX items. Growth CAPEX is directly linked to future revenue growth: if you model accelerating revenue without corresponding growth CAPEX, your model has an internal inconsistency.

This distinction matters for return on invested capital analysis. Growth CAPEX creates new invested capital on which the company must earn a return exceeding its cost of capital. Maintenance CAPEX simply preserves the existing asset base. Mixing the two produces muddled ROIC analysis. See our guide on growth CAPEX vs maintenance CAPEX for a deeper treatment.

Total Asset Growth and Net Fixed Asset Growth

In the ValueModel framework, total asset growth should broadly track revenue growth over time. If a company’s assets grow significantly faster than revenue, it is either investing aggressively in future capacity or capital efficiency is deteriorating. If assets grow far slower than revenue, capital efficiency is improving, which is generally positive but warrants scrutiny to confirm it’s sustainable.

A useful rule for net fixed asset growth (growth in Property, Plant & Equipment net of accumulated depreciation): even at 0% revenue growth, net fixed assets should grow at least 3% per year. Why? Inflation. Replacing a machine that was purchased 10 years ago costs more than the depreciated book value, even if the capacity is unchanged. A model that assumes flat or declining net fixed assets during a maintenance phase implicitly assumes the company can replace assets at historical cost, which is rarely true.

How to Forecast CAPEX in a Financial Model

There are several defensible approaches to CAPEX forecasting, each appropriate in different contexts:

1. CAPEX as a % of revenue: Most common. Derive a historical average (5-year), adjust for any known capacity step-changes. Works well for stable, asset-intensive businesses.
2. CAPEX at ~150% of depreciation: Useful for steady-state assumptions, particularly in terminal value. Anchor to the Stotz benchmark and adjust up or down based on growth expectations.
3. Bottom-up build from management guidance: For capital-intensive projects (oil platforms, data centres, rail infrastructure), management-guided project CAPEX is more reliable than any ratio-based estimate.
4. Decline from current levels: For businesses in the investment phase transitioning to steady state, CAPEX as % of revenue typically declines as growth moderates. Model this explicitly rather than applying a flat ratio.

The most critical rule: never assume CAPEX equals zero in a terminal value calculation. This systematically overvalues every business. Companies require ongoing investment forever; that is the economic reality that free cash flow models must reflect.

Also, remember: in perpetuity, depreciation cannot exceed CAPEX. A company cannot depreciate assets it has not purchased. If your model’s terminal year shows depreciation exceeding CAPEX, you have an error that inflates terminal free cash flow and therefore inflates intrinsic value. Fix it before presenting the model.

Common Mistakes in CAPEX and Depreciation Modeling

• Setting CAPEX equal to depreciation in the terminal year: This ignores inflation and implies no growth investment. Use 150% of depreciation as the base case.
• Assuming CAPEX falls to zero in years 5–10: Extremely common in analyst models and a source of significant upward bias in valuations. All companies require ongoing investment.
• Not distinguishing maintenance from growth CAPEX: Mixing these produces inconsistent ROIC analysis and muddled FCF interpretation.
• Modelling declining net PP&E during a maintenance phase: This implies the company is physically shrinking, fine for an explicit wind-down scenario, not for a going-concern assumption.
• Using accounting depreciation as a proxy for economic depreciation without scrutiny: For many industries (technology, biotech), accounting depreciation significantly misrepresents economic asset consumption.

Frequently Asked Questions