Since 2000, the average annual return for microcap* stocks with positive trailing 12 month free cash flow is 18.39% versus 0.89% for microcaps which are free cash flow negative.
Free cash flow is operating cash flow minus capital expenditures. Why has positive free cash flow been such a major predictor of returns? No firm is sustainable unless more money comes in than goes out. Why not use earnings? The income statement is incomplete for smaller companies. Consider just two reasons why:
- Earnings includes money that is owing to the firm but not yet paid. Ever have that friend which owes you money but never pays? Cash flow statements makes no such assumptions. It is simply money in and money out.
- Earnings will reflect amortizing capital expenditures. What if it took you $3 to make $1? A dumb business right? Once you amortize the $3 capital expenditure over 20 years, you could show huge positive earnings in the first year even though you are ultimately losing money. The cash flow statement will show this as a negative right away. A firm with positive earnings can still go bankrupt if they are not cash flow positive.