In the last chapter we defined the intrinsic value of a firm's stock as follows.

The intrinsic value is the present value of future dividends discounted at the appropriate risk adjusted interest rate (the cost of equity capital). 

We now distinguish between accounting and economic dividends by making the following observations.  The accounting system measures what dividends were paid given the legal constraints that dividends can only be paid out of current accounting income or accumulated retained earnings.   In contrast, an economic dividend is the dividend that could be paid by a firm.  This implies that it is not determined by a firm’s actual dividend policy, but of course, we need to formalize what is meant by “could be paid.” 

To motivate this, consider the following definition of economic income due to Hicks (1939): economic income is the maximum value one can consume during the week and still expect to be as well off at the end of the week as at the beginning."   

For a firm, an economic dividend is the maximum amount that could be paid without hampering the firms operations, diminishing its productive capacity, or growth potential.  The intrinsic value is then redefined as the present value of economic dividends.  In practice, the economic dividend is measured by the free cash flow to equity, which is defined as “the amount of cash that can be paid to the stockholders of the company after all expenses, reinvestment and debt repayment.”  Since the free cash flow to equity takes into account reinvestment and all expenses, it is conceptually equivalent to an economic dividend.

In this approach, it does not matter whether or not a stock actually pays dividends when assessing its intrinsic value.  What matters is its ability to generate free cash flows.

Example: Free Cash Flow and Amazon.com 

At the time of the writing of this section, Amazon.com (AMZN) traded around $120 per share even though it pays no (accounting) dividends.  However, Amazon.com was generating free cash flows. In fact, in Amazon.com’s 2009 10-K filing, Item 7, the management is very clear about their focus on free cash flows:

Management’s Discussion and Analysis of Financial Condition and Results of Operations: “Our financial focus is on long-term, sustainable growth in free cash flow per share. Free cash flow is driven primarily by increasing operating income and efficiently managing working capital and capital expenditures.”