Cashflow reveals more truth about a company than most other items. It can be a great base for building valuation and quality metrics, but still, there are some caveats:
- Large inventories: Did you know that car rental companies fleets are largely inventory, which means growth and shrinkage of their fleet goes through operating rather than investing cashflow?
- Short Asset Life: Some cutting-edge technology gets obsolete very fast. As an example, while some chip makers look great on operating cashflows, they need to invest heavily to stay in the game. In fact, the number of chip manufacturers has dramatically shrunk over the years.
- Misclassification of investment cashflow: Some companies still capitalise R&D expenses, flattering operating cashflow, especially when compared to competitors which expense everything.
- Milestone payments: Common in biotechs and construction, these can lead to very attractive metrics in one period, and very bad ones in the following period.
- Working capital changes: One of the good features of cashflow is that it highlights the cost of growth. Firms with long payment cycles will require more capital to grow, potentially eating into investors’ returns. By contrast, firms such as Amazon who get paid before they have to pay their suppliers are the kind of growth you want. In general, avoid growing firms with long or deteriorating payment cycles. Also, don’t get fooled by shrinking firms that release working capital in the process – this is a one-off process that cannot be repeated.