Thanks to a massive boost from the coronavirus pandemic, Etsy (ETSY 0.34%) saw its growth absolutely surge a couple of years ago. Online shopping enjoyed huge demand from consumers. And as a popular marketplace for unique and handcrafted goods, Etsy benefited tremendously.

The financial gains have slowed due to macro headwinds, though. This could still be a magnificent growth stock. However, there's one major red flag that investors can't ignore.

Reasons to be bullish

My stance on Etsy as a solid investment opportunity hasn't changed. One of the most compelling reasons is its differentiated product offering. A survey revealed that 87% of Etsy shoppers found items on the site that they couldn't find anywhere else. This is a remarkable competitive advantage. And it protects Etsy from the likes of Amazon, which focuses more on speed and convenience.

Etsy also benefits from network effects, which support its economic moat. It's a two-sided marketplace with 97.3 million buyers and 8.8 million sellers that increases in value for all stakeholders as it gets larger. If I wanted to create a competing platform from scratch, it would be impossible.

This is typically a very successful company from a financial perspective. Etsy is a capital-light operation because it doesn't own inventory or warehouses. And this leads to consistent free cash flow, something you usually don't see with growth businesses.

Moreover, the stock is cheap. Because it's currently 72% below its highest level from November 2021, shares are trading at a forward price-to-earnings multiple of 17.4. This represents a discount to both the S&P 500 and the Nasdaq-100.

The red flag: Capital allocation

Perhaps the most important task of a leadership team is to successfully allocate capital. As owners of a company, shareholders should demand that management is doing what's in their best interests. Through this lens, investors will find a glaring red flag with Etsy.

In 2021, the business acquired Elo7 (for $217 million) and Depop (for $1.6 billion), two smaller e-commerce marketplaces that could create what CEO Josh Silverman called a "House of Brands." Elo7 is known as the Etsy of Brazil, and Depop is a secondhand fashion reseller. The strategic rationale for these purchases was that they could complement the main Etsy marketplace by giving buyers an even bigger range of merchandise.

But about a year later, during the third quarter of 2022, the management team reported an impairment charge of just over $1 billion to write down the goodwill value related to those two acquisitions. In other words, the value of these assets wasn't as high as originally thought.

That impairment charge is a clear admission that the CEO and his team massively overpaid for those two acquisitions. In fact, Elo7 has already been sold off, so it ended up not even working out from a strategic perspective.

"We purchased these businesses when technology and consumer company valuations were at much higher levels," CFO Rachel Glaser said during the Q3 2022 earnings call. The market was certainly frothy at the time, as stocks and cryptocurrencies were experiencing a bull market in 2021.

A $1 billion write-down is nothing to sneeze at. As of this writing, Etsy's market capitalization is $10 billion. If that $1 billion had instead been used to buy back stock, the company's outstanding share count would be a whopping 10% lower right now.

The hope is that executives learned from this costly mistake, and that they will be smarter about how they allocate capital. This is their financial duty to their investors.