As active portfolio managers, we seek to identify and exploit inefficiencies in the marketplace. One major inefficiency, in my view, is the common fixation on earnings-based valuation metrics. Focusing on free cash flow, rather than net income, EBIT or EBITDA, allows us to find valuation arbitrage opportunities based on gaps in accounting earnings and free cash flow.
A meaningful discrepancy frequently occurs between reported earnings and free cash flow in working-capital-intensive businesses.
Is working capital the worst kind of expense?
Working capital – the sum of receivables and inventories, minus payables – is the worst kind of expense. A business with growing revenues and positive net working capital requires incremental cash outlays in the form of working capital to support continued revenue growth. This can come in the form of inventory expansion (partly offset by payables) or further credit expansion, for example. Unlike capital expenditures, which are eventually charged to operating income through depreciation and amortization, this working capital spending never flows through the income statement as an operating expense.
Moreover, other expenses, including most forms of depreciation and amortization are tax deductible. But working capital expansion is not. Cash consumed through incremental working capital requirements is the worst kind of expense: not tax deductible and never recognized on the income statement – out of sight and out of mind to both investors and many management teams.
The real perils of working capital
To illustrate the magnitude of the potential drag net working-capital demands can have on a growing business’ free-cash-flow generation, let’s look at a simple example.
Assume a business is growing at 5%, has 10% operating margins and a net-working-capital requirement of 25% of total revenues (receivables plus inventories, minus payables, all divided by revenues). Each year the business consumes the cash equivalent of 12.5% of its operating income merely to fund the working-capital growth necessary to sustain the business. The impact on free cash flow is even greater, due to the inability to deduct working capital for tax purposes.
Because many market participants value businesses based primarily on earnings, one would expect businesses that are working-capital intensive, all other aspects being equal, to trade at materially higher price-to- free-cash-flow multiples than their working-capital neutral and negative-working-capital brethren.
Since free cash flow is the ultimate driver of long-term shareholder value, in my view investors may find consistently more favourable opportunities in businesses that are not working-capital intensive.
The positives of negative working capital
There is one caveat to my “worst kind of expense” argument about working capital: The exact opposite is true for companies with negative working capital – companies with payables balances and/or deferred revenues that exceed receivables and inventories. Such businesses generate positive cash flow from working capital as they grow, since the incremental receivables and inventories required to support growth are more than offset by free funding from suppliers and/or prepayments from customers.
For a growing business with negative working capital, working capital is not an expense at all, but rather a source of interest-free cash that keeps growing and growing. As a result, in a marketplace that consistently values businesses using earnings-based metrics, investors may find even more interesting opportunities in negative-working-capital businesses.
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