How investors can factor negative cash flow into valuations
NOTNegative cash flow can be a truly horrible metric for a business – or it can be a sign of a healthy, growing business. How can an investor tell the difference? In this episode of “The Morning Show” on Motley Fool Live, recorded on December 21, Fool analysts John Rotonti and Jim Gillies discuss how to use metrics in your valuations of a stock.
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John Rotonti: If our definition of free cash flow is NOPAT [net operating profit after tax], could this new capital invested. It just means that in one year the new invested capital is higher than NOPAT. Now that can be a really good thing. It can be, in fact, an incredible and value-generating thing if the business generates high returns on invested capital. How to calculate the return on invested capital? Same exact numbers. NOPAT on the average invested capital. If the business has a high underlying profitability, a strong business economy. If it is generating a high return on its invested capital, then you want the company to invest every last dollar it has, and then some, in those high return investments. It may be beneficial for some managers to have negative free cash flow early in the life of the business if the business has high underlying profitability, good unit economics, and higher returns on the business. invested capital. ‘Until recently, Netflix had, believe it or not, a good return on invested capital, but negative free cash flow. The only thing the market focused on was negative free cash flow. But in fact, his returns on invested capital were increasing every year. This is a clear sign that as soon as he cuts his spending a bit, his free cash flow will start to increase, and now they’re at this inflection point, they’re saying their free cash flow is going to start growing. Negative free cash flow can be a terrible thing or a good thing. It all depends on the business and the underlying economy.
Jim Gillies: The only caveat I would give here is that the DCF is of course based on future estimates of free cash flow.
Rotonti: To the right.
Gilles: We are not looking back, we are looking forward. If all of your future free cash flow forecasts are negative, you should probably move on to another security to look into. [laughs]
Rotonti: Totally, if you don’t see it evolving.
Gilles: Yes, negative free cash flow should be a problem that resolves itself fairly quickly. If not, well, [laughs] next business.
Gilles: You don’t want to value every business based on free cash flow. It is not a great tool, for example, for financial companies. Debt is a commodity for one finance company, while for another it can be a straitjacket. But for a bank or for a consumer lender, debt is a commodity, so that doesn’t get you excited. But also, you will not be able to model the cash flow per se, because this cash flow is going to be obtained very quickly, probably several times per accounting period as well, by the way, if it is a shorter term. That cash flow is going to be paid back to make new loans and make more loans and be recycled over and over again. What ends up happening is a situation where you’re like, okay, book value style analysis, reported profits, if I can understand, is driving profits, this might be a better tool. to use for evaluation versus free money flow. But if you look at a Home deposit, or one Starbucks, or one Garmin, or a grocery store, free cash flow is the place to be.
Rotonti: Yeah, go ahead.
Maria Gallagher: Go ahead. I was just changing the subject.
Rotonti: I’m just saying, I put a quote from Michael Mauboussin in the chat and link. The quote is: âTo be clear, negative free cash flow is not only good but desirable when the return on invested capital is attractive. But 100%, Jim, if you don’t see this thing moving towards positive free cash flow, Avoid like the plague.
Jim Gillies owns Starbucks. John Rotonti owns Home Depot. The Motley Fool owns and recommends Home Depot, Netflix, and Starbucks. The Motley Fool recommends Garmin and recommends the following options: $ 115 short calls in January 2022 on Starbucks. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.