Super Cash Flow Company

"In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business is determined by the cash inflows and outflows-discounted at the appropriate interest rate that can be expected to occur during the remaining life of the asset." - Warren Buffett

The Indian Internet sector is still in the early innings of evolution. Simply put, `connectivity' and `convergence' are powerful secular trends, and a handful of companies will witness a huge growth in market share, owing, in part, to "Network Effects".

Traditional valuation, such as P/Es and earning growth rates, offers little or no guidance to investors trying to value Internet stocks. Like all businesses, Internet companies are valued on their ability to generate cash. If Internet companies have higher valuations than their offline counterparts, the market must believe that they have higher cash flows.

Internet Company has a drastically different cash economics than their Old Economy counterparts. It invests much less in their computers and office space than Old Economy companies spend on bricks-and-mortar and working capital. Its online business model means that it can reach new customers and grow sales without spending lots of cash. This has several benefits. First, because consumers can access web sites from any Internet connection, it can grow its revenues rapidly without having to endure long delays as it scales its physical infrastructure. This increases sales, and allows the company to "lock-in" customers before other competitors acquire them. Second, because it does not have to spend much money to serve an incremental customer, revenue growth translates rapidly into higher margins.

A company's propensity to generate or consume cash through earnings or investments determines the nature of its business model. As Figure below indicates, companies tend to fall into one of four categories:

Traditionally, successful companies have a cash inflow from earnings, and a cash outflow from its investments in working capital and bricks-and-mortar stores or factories. Companies that fit this profile are in the upper-left Profitable Buildout quadrant of the diagram.

But there are some exceptional companies in the Internet space that falls in the upper-right Super Cash Flow quadrant as it has both earnings and investment as a cash inflow. They have negative working capital, which means that their working capital is financed by interest free cash loans from customers and suppliers. They also do not require huge capital expenditure. This is because once the fixed cost of operating a website is spent, it is relatively inexpensive to scale up capacity to meet increased demand. This makes it one of the rare companies with cash inflow from investment.

Thus, a few Internet companies generate a cash inflow from its income statement and balance sheet, making them one of the rare companies in the Super Cash Flow quadrant.

In the past, investors have focused solely on the income statement to find the important source of cash inflow. However, looking at the balance sheet of a New Economy company can unveil an important source of cash. Investors must look at both financial statements, as it is free cash flow, the sum of a firm's cash earnings and investments that drives shareholder value creation.