Unlevered Free Cash Flow Tutorial: Definition, Examples, and Formulas (20:30)

What is Unlevered Free Cash Flow (FCF)?

Unlevered Free Cash Flow, also known as UFCF or Free Cash Flow to Firm (FCFF), is a measure of a company’s cash flow that includes only items that are:

• Related to or “available” to all investors in the company – Debt, Equity, Preferred, and others (in other words, “Free Cash Flow to ALL Investors”) AND
• That are recurring for the company’s core-business operations.

You can see how we calculate it in real life for Steel Dynamics (STLD) in a screenshot of our DCF model for the company below:

We use Unlevered Free Cash Flow in a Discounted Cash Flow (DCF) Analysis to value a company, and we start by projecting the company’s Unlevered Free Cash Flow over 5, 10, or even 20 years.

Then, we discount the UFCFs to their Present Value at the appropriate discount rate, estimate the company’s value from the end of the projection period into infinity (the “Terminal Value”), take the Present Value of the Terminal Value, and add these two components together to determine the company’s Implied Enterprise Value.

You can see how everything ties together in the screenshot below for Steel Dynamics:

Unlevered Free Cash Flow Formula

Each company is a bit different, but a “formula” for Unlevered Free Cash Flow would look like this:

• Start with Operating Income (EBIT) on the company’s Income Statement.
• Multiply by (1 – Tax Rate) to get the company’s Net Operating Profit After Taxes, or NOPAT.
• Add back the company’s Depreciation & Amortization, which is a non-cash expense that reduces its taxes but which does not “cost” it anything in cash in the current period.
• If the company has Deferred Income Taxes or other recurring items that affect its cash flow, also factor those in.
• Add or subtract the Change in Working Capital, which indicates how the company is managing payments from customers, inventory, bills from suppliers, and other receivables and payables.
• Subtract Capital Expenditures (CapEx), which represents re-investment into the company’s business in the form of spending on long-term assets such as land, factories, buildings, and equipment.

Unlevered Free Cash Flow = Operating Income * (1 – Tax Rate) + Depreciation & Amortization +/- Deferred Income Taxes +/- Change in Working Capital – Capital Expenditures

Why do we ignore the Net Interest Expense, Other Income / (Expense), Preferred Dividends, most non-cash adjustments on the Cash Flow Statement, most of Cash Flow from Investing, and all of Cash Flow from Financing?

Here’s a short explanation for each one:

• Net Interest Expense – This relates only to the Debt Investors, i.e., the lenders, and is not available to all the investors in the company. Common shareholders do not receive these payments at all. Therefore, we ignore it in the Unlevered FCF calculation.
• Other Income / (Expense) – This is related to non-core-business activities, such as side businesses in other areas, so we ignore it.
• Preferred Dividends – Often shown toward the bottom of the Income Statement, this one relates only to the Preferred Stock investors and is not available to all the other investors in the company. Therefore, we ignore it.
• Most Non-Cash Adjustments on the Cash Flow Statement – Many of the other items here, such as Gains and Losses, are non-recurring and have nothing to do with the company’s core-business operations. Therefore, we ignore them.
• Most of Cash Flow from Investing – See above; outside of Capital Expenditures, most of the CFI section of the Cash Flow Statement represents non-recurring items that are related to optional “side activities” like buying and selling securities.
• Cash Flow from Financing – Every single item here relates to only one investor group, such as common shareholders or lenders. Also, many of these are non-recurring. Therefore, we ignore this entire section of the Cash Flow Statement.

Here’s how we put these rules into practice for two real companies, Steel Dynamics and Snap:

Example for Steel Dynamics

Let’s start by looking at Steel Dynamics’ Income Statement. If an item is highlighted in yellow, we include it in Unlevered FCF; if it’s not, then we ignore it:

We include the common items above, and we ignore the Asset Impairment Charges (non-recurring), Net Interest Expense (only available to Debt investors), and Other Income / Expense (non-core-business activity).

We include but modify the Income Tax Expense, and instead of Net Income on the CFS, we use NOPAT, equal to EBIT * (1 – Tax Rate), instead.

And then moving down to the Cash Flow Statement:

On the Cash Flow Statement, we include the Depreciation & Amortization add-back, ignore Impairment Charges and Gains/Losses (non-recurring), and ignore Stock-Based Compensation (affects only the Equity investors, changes share count, and is not a real non-cash expense).

We do include Deferred Income Taxes as well because a DCF should reflect the company’s actual Cash Taxes paid, but they decrease as a % of Income Taxes over time and should not be a major value driver for most companies.

Then, we keep everything in the Change in Working Capital section, we keep CapEx in Cash Flow from Investing but drop everything else, and we ignore everything in Cash Flow from Financing (items are non-recurring, or related to just Equity or just Debt investors).

Example for Snap

The Income Statement is very similar for Snap:

Once again, we’ll modify the Income Tax line item because we’ll base it off Loss from Operations rather than Loss Before Income Taxes.

We ignore Interest Income and Interest Expense.

Here’s the Cash Flow Statement:

Once again, we’ll start with NOPAT rather than the Net Loss at the top, and we include D&A and Deferred Income Taxes but ignore the rest.

We include the entire Change in Working Capital section, and then CapEx and the Purchases of Intangible Assets… maybe.

This last one is a bit subjective, but we’d say it’s fair to include for Snap since it’s a tech company that acquires a lot of patents, intellectual property, and smaller startups on a consistent basis.

Lingering Questions About Unlevered Free Cash Flow

You probably have a few more questions about Unlevered Free Cash Flow, so here are the most common questions we’ve received and the answers to them:

QUESTION #1: What about Stock-Based Compensation (SBC)?

ANSWER: No! Never count it as a non-cash add-back because it increases the company’s share count (see our video on this topic)

QUESTION #2: What’s the deal with Deferred Taxes?

ANSWER: In a DCF, you want to reflect the company’s Cash Taxes, so you use Deferred Taxes to account for the Book vs. Cash Tax difference…

…but they should not be a huge value driver, which is why they usually decline as a % of Income Taxes over the long term.

QUESTION #3: What about impairments and write-downs?

ANSWER: These are non-recurring items, so you always ignore them.

QUESTION #4: What about an add-back for non-cash (PIK) Interest?

ANSWER: Nope! You should completely exclude all forms of Interest, so you can’t add back a component of a non-existent item.

QUESTION #5: What about Purchase of Intangibles?

ANSWER: Maybe – if they’re truly recurring and you count the Amortization from them, you may include these along with CapEx. However, this one greatly depends on the company and industry. It’s easier to justify for software or biotech firms, but much harder to justify for industrials companies.

QUESTION #6: What goes in the Change in Working Capital? The company’s doing something that doesn’t match the definition!

ANSWER: Use the company’s version on the CFS. If they think the item’s operational, assume that it is (possible exception for DTAs and DTLs – it’s better to skip them and just show Book vs. Cash Taxes in the Deferred Tax line).

Make sure you check out our tutorial on the Change in Working Capital for more on this one as well.

QUESTION #7: What if the company is highly acquisitive?

ANSWER: You can include cash outflows for the acquisitions and the additional revenue/expenses from them in future years, but eventually they should go to 0, and the company’s FCF should “normalize.”

It might be OK to assume ongoing acquisitions if they’re relatively small, but you should not be assuming the company keeps doubling in size due to acquired companies or its Free Cash Flow growth rate will never fall to a reasonable percentage by the end.

QUESTION #8: Some people define Unlevered FCF by taking NOPAT and adding all the non-cash adjustments shown on the CFS instead of just D&A and Deferred Taxes… why?

ANSWER: Sometimes people make “quick estimates” to analyze the historical statements and don’t bother to separate out the charges…

…but for valuation purposes in a DCF, you should use the definition here and project only the line items that go into Unlevered FCF.

Be careful because people use inconsistent definitions and terminology! Yes, there are numbers, but this is far less rigorous than “real math.”

About Brian DeChesare

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.