Snowflake: free cash flow vs. GAAP net income

Hello, I'm Professor Michael McDonald. I'm a professor of finance at Fairfield University in Fairfield Connecticut. Today, I'd like to talk to you about one of the most interesting corporate stories in the last few years, and that is Snowflake. Now you may or may not be familiar with Snowflake, but it's a software company. And what we're going to look at today is the dichotomy between free cash flows and GAAP net income.

Now, there's a variety of firms out there that trade in the stock market. Many of those firms have long histories and might be solidly profitable but with relatively low growth prospects over time. In contrast, there are numerous publicly traded companies that have either minimal or no accounting profit at all, either under the US GAAP standards or the international IFRS standards. That's very common to see. We could name many technology companies, software companies, and things like that. Yet these firms are oftentimes commanding very high stock prices; Shopify, Uber, HubSpot, Spotify, Salesforce, Snowflake. They're all examples of this. So that begs an important question. Why do these firms have positive share prices, oftentimes very high share prices, and substantial market capitalizations, if they're not earning any profit? The basic foundation of finance tells us the value of a stock is, in the most simple form, V = D1/(K-g). Something we all see from the first finance class we take. The value of the company is equal to dividends for the upcoming year divided by the cost of capital minus the growth rate. Conventional finance then tells us if a firm doesn't have any dividends this year, next year or on the horizon, we really can't make an intelligent valuation about the firm. We have to do something very speculative. So why is it that these firms have very high stock prices? This is often confounding to university students that I'm teaching. The answer to the question is that investors are expecting long-term high levels of growth so the current earnings don't matter much. And that's a pretty straightforward concept. Most people understand that, hey, even if this firm isn't generating profits right now, we think that over the next 10 years, they're going to grow markedly and they'll have big profits going forward. So, certainly, that's one answer. But there's another answer which is more subtle, but arguably more important. Earnings, as we report them, under either GAAP or IFRS, are accounting earnings. That may or may not capture what investors actually care about, which is cash flow. I don't care at all about Snowflake's accounting earnings. If they have positive GAAP income, that's great. If they have negative GAAP income, that's fine too. I don't care. What I actually care about is the level of cash flows produced by the company and hence by my investment. That's what investors are looking for. They're looking for a cash return, a financial return, on their investment. And how do they get that financial return? Through the generation of cash. Accounting earnings are just numbers on a piece of paper. Cash earnings are what actually goes into the bank account and ultimately can get paid out to shareholders or used to grow the company further.