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! =)
- An article by Roger Montgomery, a Buffett-follower, at Clime Asset Management here: Questions of Value – An Examination of the 2-Stage Model; and
- 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.
- 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.