DCF - Why add discounted FCF to terminal value? What is FCF if not dividend


I’m hoping that someone here could help me climb out of this black-hole that I’ve gotten myself into thinking about DCF valuation.

I don’t have a problem with this: If one had perfect foresight into the future, the value of a company today would be its sale price in the distant future, plus all the payouts it has made to its investors, discounted appropriately.
IOW, a stock price ought to be the discounted value of its dividends plus the value of its sale price on a certain future date, discounted to todays date.

DCF does the same by adding up the FCF and the terminal value. The point where I am confused is, why do we add up the FCF’s? if they have not been paid out to the investors. IOW, should it not just be the terminal value discounted to today?

Therefore my question boils down to what is FCF if it is not the dividend?. i.e., If the FCF is not paid out, then by default it is considered reinvested and isn’t that what produces the terminal EPS and futue cash flows?

There’s a reason that ‘free’ cash flow is used. This is the amount that is not needed by the business. It doesn’t have to ploughed back in but its upto the management to decide what to do with it. If they feel that there is no benefit by ploughing back the amount they will give it all out as dividend. If they feel that the free cash flow will aid the business growth then they will plough it back in, and you can expect it to generate an incremental return that’s equivalent to the Return on Equity (RoE).

Take an example of a fixed deposit. Lets say you make a FD of Rs 100 that will generate 10% interest ever year for 10 years. You have two options:

  1. Take the annual interest of Rs 10 and use it elsewhere.
  2. Add the Rs 10 back to FD amount and thus get higher interest each year.
    Would the terminal value be the same in both cases?

Because the FCF is not paid out to stakeholders, the terminal value would be higher compared to what it would have been if FCF had been paid out.

Yes, you’re right. But reinvesting should give you a higher terminal value.

That’s the reason one wants to invest in a business that can not only generate very high free cash flow & high return on capital (say FMCG companies, IT) but also redeploy that capital at the same high rates of returns. I think that is what produces a multi-bagger.


Thank you for your time.

Let me see if I get this…
Say, I see a business that is growing by 30%. If I understand you correctly, here by FCF, we mean the cash left over, even after accounting for this 30% growth?

IOW, if a company has an ROE of 30% and it ploughs back the profits generated in a year to produce more of its product and there by it grows by EPS by 30%, … then this profits are not considered FCF, because it is they that cause the 30% growth. IOW, if we use an earnings projection of 30% growth rate, then my TV represents all the cash that has been added back to produce this 30%. Anything in excess of that, needs to be added at a discounted rate to TV, because the my projection at this point in time, didn’t account for this excess that has been ploughed back which may cause the actual TV to be greater than TV I computed.

Unfortunately this FCF is quite difficult to gauge accurately, since companies grow both organically and inorganically. ROE/EPS at point T, doesn’t distinguish what comes through the inorganic growth vs organic growth.


I think our definitions of free cash flow may not be the same. Are you considering FCF to be ‘Cash flow from operations - Cash spent on capital expenditures’?

The way I think of FCF is…it is the money that a company can do without, and still maintain its growth rate.

Of course, it’s not easy and it’s all made up. You can tweak numbers here and there and get the answer you want.

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Rather than the future, lets take up the past… If a company decided not to pay out its earlier CF as dividend and decided to reinvest that, say went an acquired some other company, then this will actually show up in Capex and therefore not show up as FCF, if we simply used the formula FCF = CF op - CF invest. It becomes necessary to distinguish that part of cash invested for growth in regular operations and the balance that remains as FCF (even if had been invested the same year instead of being paid out as dividend.)


The way I think of FCF is…it is the money that a company can do without, and still maintain its growth rate.

That sumarizes it. If I use a projection of a certain growth rate, the FCF porition is that which is left over beyond what it takes to achieve that growth rate. So needs to be added. Discounting it to present time assumes zero investment returns from this portion thereafter (which is fair enough, since even if the management mis-invests it (thereby reducing overal ROE), it only leads to a greater value than projected, unless it ran into losses. )

Maybe the real question is how ‘free’ is the free cash flow? If I think of the example you gave and compare that to the FD example mentioned earlier, I see no contradiction. Not sure if I helped you out of the black-hole or pushed you further in!

It helped. Thanks. I was caught in the theoritical thought that when FCF is reinvested, its impact is on the final EPS, nothing is really paid out to the investor and therefore should not be added. But then projecting it today, I’m not accounting for that increase in EPS. In this I ought to bear in mind, that this is excess of the CF post the cost of the projected rate of return.

Thanks. Helped me clear up my thinking too. I should have been more clear on the definition of FCF: ‘Cash flow from operations - Cash spent on maintenance capital expenditures’. But you got what was implied.

Great discussion

I guess we are trying to figure out two different aspects in combination
i.e. free cash flow and capital allocation.

During a capital budget exercise i.e. if I buy asset how much return I
should expect from an asset. John Burr Williams first floated the idea it
should be equal to present value of future cash flows, nothing more and
nothing less. The same analogy is use in intrinsic valuation of a company
considering it as capital asset producing returns. I do have personally
divergent views on using cash flow as a major tool against valuation of
company. Why, may be this is not what is asked here.

I can create an economic value only by investing capital and generating
return. The capital can go to operating expenditure or capital expenditure,
balance left out is free cash flow. Basically FCF/Capital is the cash I can
take out from company without materially impacting operations. Management
has to decide how to allocate this capital or FCF?

  • by paying dividend (financing activities)
  • by buying back shares (financing activities)
  • by acquisitions (investing activities)
  • by reinvesting in business ( a new line of business or invest to existing
    business as expansion- Growth capex)
  • by retiring debts (financing activities)

Note- some people separate growth and maintenance capital expenditure
because one is to maintain asset, second is to create growth or considered
as investment. In this case FCF is cash flow from operations minus
maintenance capital expenditure.

Capital allocation back to reinvestment- same way if I have to invest stock
market profits back to market for me the comparison would be 1. against a
risk free rate say liquid funds say 7-8%. 2. cost of capital incurred in
bringing the capital. Meaning how much leverage or funds I have utilised
for business; say loan at 12%. In this case if I am not leveraged minimum I
should expect is 8% plus, if leveraged should be 12% (I am ignoring tax

It only makes sense for a company to reinvest in business when there is a
economic profit i.e. return adjusted after factoring cost of capital. For a
company it’s the ROIC or Return on Capital Employed is compared against
cost of capital to know economic profit of a company. ROIC considers all
type of capital including bonds, temp cash credit etc. Return is extracted
using core operations number i.e. NOPAT (Net operating profit after taxes).
ROE can be used also, however it takes below the line numbers, if you are
using ROE make sure you have adjusted the differences of leverage every
year i.e. favourable debt increases the ROE through capital leverage than
operational catalyst.

Why dividend is considered for DCF valuation? Because it has been already
paid to you. Similarly while calculating cost of capital ignore dividend.


Thank you for chiming in.

Using FCF to purchase back shares is a very good example…
So if I have a company growing at a steady 30% even after paying out a dividend of say 70% of its profits, then I would compute TV based on that 30% and also add the dividends discounted appropriately. Now if the same where not paid out as dividends but used to repurchase shares, then still the TV is the same based on the 30% growth, but this amount is divided among much lesser shares.

On the other hand, if I see that the company is growing EPS at 30% paying out no dividends and instead repurchasing its shares, then in that case, the present value is simply the TV discounted to today, since the repurchases are already accounted for in the 30% growth, so they aren’t exactly the same as FCF’s that I ought to be adding as per the DCF formula.

So it all boils down to removing of the cost of growth and adding the rest along with TV.
(I do understand the above is quite oversimplified and perhaps its incorrect to assume that the company is growing
by 30% when that growth is achieved by repurchase of shares…)

Thanks for taking the time to elaborate on NOPAT and ROIC and the caveat with ROE. I do understand these. However I still haven’t got to a level of competence to begin using these.

You hint at the point

True, DCF will have us believe that at the terminal year, a company having a networth of 10 billion or 100 billion doesn’t matter, but what matters is simply the Earnings you generate out of it, which will clearly not be the case if the company was liquidated right away at that time. But right now, I’m just looking for something simple that I can rely on, just can’t make it to complex to arrive at a accurate figure, a rough sense of direction will do.

You are right, DCF has pluses and minuses. Have you tried Bruce Greenwald franchise valuation, and if yes are you not happy? I mean it uses both reproduced PL and BS with growth to future.