How Investors Can Factor Negative Cash Flow Into Valuations
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.
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.
Source Fool.com