How Investors Can Factor Negative Cash Flow Into Valuations

It can signal good things or bad things about a company — and it’s up to investors to know the difference.

Negative cash flow can be a truly awful metric for a company — or it can be the sign of a healthy, growing business. How can an investor know the difference? In this episode of “The Morning Show” on Motley Fool Live, recorded on Dec. 21, Fool analysts John Rotonti and Jim Gillies discuss how to employ the metric into your valuations of a stock.

How Investors Can Factor Negative Cash Flow Into Valuations

John Rotonti: If our definition of free cash flow is NOPAT [net operating profit after tax], might this new invested capital. All it means is that in one year, new invested capital is more than NOPAT. Now, this can be a very good thing. This can be, in fact, an incredible, value-generating thing if the company is generating high returns on invested capital. How do you calculate return on invested capital? Same exact numbers. NOPAT over average invested capital. If the company has high underlying profitability, strong business economics. If it generates a high return on its invested capital, then you want the company investing every last dollar it has, and then some, into those high-return investments. It can be a good thing in the hands of certain managers to have negative free cash flow early in the company’s life if the company has high underlying profitability, good unit economics, and higher returns on invested capital. ‘Til recently, Netflix had, believe it or not, it had good returns on invested capital, but negative free cash flow. The only thing that the market focused on was the negative free cash flow. But in fact, its returns on invested capital were increasing every year. That’s a clear sign that as soon as it pulls back on spending a little bit, its free cash flows are going to start to grow, and now they’re at that inflection point, they say that their free cash flows are going to start to grow. Negative free cash flow can be a terrible thing or a good thing. It all depends on the business and the underlying economics.

Jim Gillies: The one caveat I would throw in there is that DCF is of course based on future estimates of free cash flow.

Gillies: We’re not looking backwards, we’re looking forwards. If your entire future forecasts of free cash flow is negative, you should probably move on to a different stock to look at. [laughs]

Gillies: Yeah, negative free cash flow should be a problem that fairly quickly resolves itself. If it doesn’t, well, [laughs] next company.

Gillies: You don’t want to evaluate all companies based on free cash flow. It’s not a great tool, for example, on financial companies. Debt is raw material for a finance company, whereas for another company, it might be shackles. But for a bank or for a consumer lender, debt is raw materials, so you don’t get excited about that. But also, you’re not going to be able to model out cash flows per se because those cash flows are going to get very quickly, probably several times per accounting period too, by the way, if it’s a shorter term. Those cash flows are going to get returned back to make new loans and make more loans and get recycled over and over. What ends up happening is, that’s a situation where you’re like, OK, a book value style analysis, reported earnings, if I can understand, are the drivers of earnings, that might be a better tool to use for valuation versus free cash flow. But if you’re looking at a Home Depot, or a Starbucks, or a Garmin, or a grocery store, free cash flow is where to be.

Rotonti: I’m just saying, I am putting a quote from Michael Mauboussin into the chat and the link. The quote is, “To be clear, negative free cash flow is not only fine but desirable when the return on invested capital is attractive.” But 100 percent, Jim, if you don’t see this thing scaling to positive free cash flow, avoid it like the plague.