I first learned about this rubric from Geoff Gannon on Focused Compounding. When looking at a company’s cash flows, one of the things to look out for is Free Cash Flow > Net Income (FCF > NI).
Gannon’s definition of Free Cash Flow is (similar to Buffett’s ‘Owner Earnings’ and is conservative):
- Cash Flow from Operations less CapEx Spending excluding any divestitures and changes in working capital.
These are “extremely rare” companies and typically is possible due to “float”, according to Gannon.
By my estimation, there’s a few broad types that might be good hunting grounds on where to look for FCF > NI:
- Subscription companies
- Linear Media (i.e. cable, newspapers)
- Online Media (i.e. streaming companies)
- Software (i.e. software-as-a-service)
- Receive Payment and then Pay later (i.e. ecommerce, drop-shipping, insurance, payroll companies)
- Crowdfunding (i.e. pre-sales for courses and/or other products)
- Deferred Liabilities (i.e. capital gains tax when sold)
- Engineering companies (i.e. locking in contracts and services for future work)
- Gift cards (i.e. customers are giving you money upfront to trade for some goods and services later)
Basically anywhere you have a consistent negative working capital cycle it’s likely have you have some form of float (big or small). Combine this with a business the does not even need the capital then there’s some synergies there.
Can you think of any more?