Valuation, Value Investing

Double counting of “free” cash flow in DCF

From my many previous posts, you can tell that I’ve been thinking for some time about this problem with the double counting of “free” cash flow that most people do with DCF, i.e. free cash flow that are re-invested are not truly free for discounting at the point in time in which they are earned.

For a long time I’ve not seen any article highlighting this issue, and in fact to the contrary, every DCF that I’ve seen simply discounts FCF in this “wrong” manner.

Well, I’m glad to finally see this issue being highlighted in a few places! =)

  1. An article by Roger Montgomery, a Buffett-follower, at Clime Asset Management here: Questions of Value – An Examination of the 2-Stage Model; and
  2. An article by Michael Mauboussin of Legg Mason here: Common Errors in DCF Models, where he highlighted the critical linkage between amount of re-investment and future growth.
  3. The Wizards of Wall Street book by Kazanjian carried an interview with Glen Bickerstaff who managed the Trust Company of the West. In there, Glen highlighted that they do not have a good feel of the future return of incremental invested capital (i.e. above mantenance level capital spending). He also uses what he calls a ‘cap rate’ as his valuation metric, which essentially is the IRR.


2 thoughts on “Double counting of “free” cash flow in DCF

  1. I’m glad I’m not the only one who figured this.

    I scanned through all my investing books and not one took into account the double counting of free cash flow in the terminal value.

    It was good to see someone else with the same thoughts (found this on Google) – I figured my maths must have been wrong…

    Posted by Alex Farris | February 28, 2012, 3:22 am
  2. Yes this is something not many people pay attention to, likely because modelling reinvestment of retained earnings is typically not taught or done in the standard Free Cash Flow discount models.

    Posted by whatheheckaboom | February 28, 2012, 2:35 pm

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