Levered Free Cash Flow and the Levered DCF: The Most Useless Concepts in Valuation? [PLEASE SEE THE IMPORTANT NOTE BELOW THE VIDEO]

Levered Free Cash Flow Definition: Levered Free Cash Flow (LFCF), also known as Free Cash Flow to Equity (FCFE), equals a company’s Net Income to Common + Depreciation & Amortization +/- Deferred Taxes +/- Change in Working Capital – Capital Expenditures +/- Net Debt Borrowings.

IMPORTANT NOTE: The video here has a calculation error with the Levered FCF numbers. Please go by the screenshots and written guide on this page and the Excel file provided here. These have all been corrected. Unfortunately, YouTube does not let us “replace” or “correct” the video, so we can’t fix this issue without deleting and re-uploading the entire video and losing all the comments and data.

Video Table of Contents:

2:10: Part 1: Basic Definition of Levered FCF and Excel Demo

5:10: Part 2: Changes Required in a Levered DCF Analysis

10:44: Part 3: U.S. GAAP vs. IFRS Differences for Levered FCF

12:53: Part 4: Why the Levered and Unlevered DCF Are Not Equivalent

16:57: Part 5: Is Levered FCF Ever Useful?

19:05: Recap and Summary

Although we always recommend using Unlevered Free Cash Flow in a DCF model, there are other approaches as well.

The one that generates the most questions and confusion is a Levered DCF based on Levered Free Cash Flow, also known as Free Cash Flow to Equity (FCFE).

The basic difference is that Levered Free Cash Flow represents the cash flow available only to the common shareholders in the company rather than all the investors.

In other words, it deducts payments to the debt investors (lenders), preferred stock investors, and any other investor groups beyond the common shareholders.

Normally, when you value a public company, you’re trying to estimate its implied share price, or how much the company’s shares should be worth.

Based on that, you might think that Levered FCF sounds more appropriate.

After all, since the goal of a valuation is to estimate the company’s implied share price, shouldn’t you use a methodology that is based on only the common shareholders?

The short answer is that while Levered Free Cash Flow may seem more appropriate initially, setting up a Levered DCF requires additional work and substantial changes to all parts of the analysis, and it produces less consistent results than the Unlevered DCF – so it is rarely worth the time and effort.

What Changes in a DCF Based on Levered Free Cash Flow?

Since the entire analysis is now based on Equity Value and the common shareholders, almost every step in the process changes:

1) Use Cost of Equity for the Discount Rate, Not WACC – Since Levered FCF is available only to the equity investors, you use the Cost of Equity for the Discount Rate since it represents only the equity investors.

2) Subtract the Net Interest Expense and Add/Subtract Net Borrowings – These items all affect the cash flow to equity investors, so you must factor them in. Effectively, you start with Net Income to Common rather than NOPAT and also include changes in the company’s Debt principal.

NOTE: There is some disagreement about what to add and subtract, with the main options being “all Debt issuances and repayments,” “just the repayments,” and “just the mandatory repayments.”

3) Calculate Terminal Value with P / E or Equity Value-Based Multiples – You’re considering only equity investors, so Terminal Value calculated with the Multiples Method should use an Equity Value-based multiple.

4) Calculate the Implied Equity Value Directly at the End – You don’t need a “bridge” between Equity Value and Enterprise Value because the Levered DCF does not produce the Implied Enterprise Value. Instead, adding the PV of each Levered Free Cash Flow to the PV of the Terminal Value produces the Implied Equity Value directly.

5) Reflect the Items Formerly in the Bridge in the Levered Free Cash Flow – So, you need to factor in the tax savings from NOLs, Interest Income and Interest Expense, Preferred Dividends, the entire Pension Expense, and more.

You must also deduct the entire Lease Expense regardless of the accounting system. And you have to include Dividends from Equity Investments, adjustments for Non-Cash Interest, and anything else that affects the items in the TEV bridge of an Unlevered DCF.

These changes may sound simple, but they’re actually quite complicated – especially items #2 and #5.

The problem is that you can’t just assume simple, constant numbers for the company’s Net Interest Expense, Debt issuances, and Debt repayments.

Instead, you need to:

1. Start with the company’s scheduled Debt repayments, as disclosed in its filings.
2. Project the Debt issuances such that the company’s capital structure stays about the same, accounting for the fact that its Equity Value will change over time. You can estimate the final-year Debt percentage by dividing the final Debt balance by the Terminal Value.
3. And then project the Net Interest Expense based on these issuances and repayments, the company’s Cash balance, and the prevailing interest rates, accounting for how they might change over time.

When interest rates are extremely low, you could simplify Step #3 and assume no Interest Income from the Cash balance, but the Debt projections alone still add a lot of work.

The beauty of an Unlevered DCF is that you can skip these projections and focus on the company’s core business and the revenue, expenses, and cash flow items associated with it:

With a Levered DCF, though, you spend far more time on these schedules that have nothing to do with a company’s core business.

Item #5 is also bad because it means you might also need separate schedules for Net Operating Losses, Pensions, and more.

You can get a sense of these changes in the simple analysis below:

Revenue and Operating Income are the same, but many items below them differ since we build to Net Income rather than NOPAT.

If this company had Preferred Stock, we’d also subtract Preferred Stock Dividends here to calculate Net Income to Common.

You might wonder why the Deferred Taxes change: how are they related to the company’s capital structure?

The answer is that the company’s Book Income Taxes are lower in an analysis based on Levered Free Cash Flow due to the Net Interest Expense deduction, so we need to reduce the Deferred Income Taxes as well.

U.S. GAAP vs. IFRS Issues in the Levered Free Cash Flow Calculation

With the issue of U.S. GAAP vs. IFRS, the main problem, as usual, lies in lease accounting.

The same items go into Levered Free Cash Flow under both systems, but with IFRS, you have to be especially careful with Operating Leases.

Specifically, since there is no “bridge” in a Levered DCF, you must deduct the full lease expense from both Operating Leases and Finance Leases in the FCF projections.

This is easy under U.S. GAAP because the Operating Lease Expense is a simple “Rent” line item on the Income Statement, and Finance Leases are often small or non-existent (and if they’re not, keep reading).

Under IFRS, however, expenses for both lease types are split into Interest and Depreciation (or Amortization) elements.

So, you must ensure that the Lease Interest and Lease Depreciation on the Income Statement are subtracted in Levered Free Cash Flow and do NOT get added back within the D&A component of Levered FCF.

In practice, that means that you’ll need to find a breakout of the company’s Depreciation (or Amortization) and add back only the non-lease portions:

If you can’t find this breakout, or the company does not disclose this information, then another option is to use the D&A as listed on the Cash Flow Statement and then subtract the Lease Principal Repayments line within Cash Flow from Financing.

In theory, this line item should be close to the Lease Depreciation for a large company with a diverse lease portfolio.

Will a DCF Based on Levered Free Cash Flow Produce Equivalent Results?

No!

Continuing with the examples from above, the Unlevered and Levered DCF analyses do not produce the same results:

They are very close, but they’re not identical for a few key reasons:

1) Lack of Equivalent Changes – If the interest rate on Debt is 5% rather than 10%, that makes an immediate impact on each Levered Free Cash Flow in a Levered DCF. But it does not impact the Unlevered DCF directly; the market value of Debt in the Enterprise Value might change, but that single change won’t be equivalent to the cumulative impact of a different FCF figure in each year of the 10-year forecast.

2) More “Volatile” FCF Numbers – Large Debt issuances and repayments may distort the numbers for multiple years, and it’s almost impossible to make them “equivalent” to the single line item for Debt in the standard TEV bridge:

3) Terminal Multiples and Growth Rates – Finally, it’s very difficult to pick Terminal Multiples that are consistent with the multiples from the Comparable Company Analysis and that imply reasonable Terminal Growth Rates and that produce output similar to the Unlevered DCF.

Is Levered Free Cash Flow Useful for Anything? What About the Levered DCF?

We strongly recommend against the Levered DCF unless someone has specifically asked you to build one.

Here are some of the many problems with it:

1) It takes more time and effort because you have to project the company’s Cash and Debt balances, Net Interest Expense, changes in Debt principal, and more.

And even if you simplify these assumptions, more judgment and guesswork are required to ensure consistency:

2) The FCF numbers are more volatile than those produced by an Unlevered DCF because the Debt principal repayments could be $0 in some years and massive in others. The company’s capital structure will heavily influence its implied share price.

3) You will NOT get the same results in a Levered DCF analysis because it is almost impossible to pick assumptions that are “equivalent” to those in an Unlevered DCF (see above).

4) There’s disagreement about how to calculate Levered Free Cash Flow. Some people factor in all Debt issuances and repayments, some factor in all repayments but no issuances, and some factor in only the mandatory repayments.

An Unlevered DCF is easier to set up and produces more consistent results that depend far less on a company’s capital structure.

There are a few specialized cases where a Levered DCF might be helpful (e.g., with Equity REITs), but 99% of the time, the Unlevered DCF is superior.

The Levered DCF works in these specialized cases because some companies, such as Equity REITs, issue predictable amounts of Debt and Equity each year and have more “level” repayment schedules than normal companies (mostly because they use far more Debt).

If you look up Levered DCFs from the large banks, you’ll find that they are almost always created for REITs or midstream (pipeline) oil & gas companies, as in the examples below.

This first one is from Goldman Sachs’ presentation to Brookfield and GGP:

And here’s a midstream (oil & gas transportation) example from Evercore’s presentation to GasLog:

Outside of the DCF analysis, Levered FCF is sometimes a good screening tool because it tends to represent a company’s real-world cash flow more accurately than Unlevered FCF.

For example, in a leveraged buyout, the private equity firm does not care about the company’s “theoretical” cash flow available to all investors.

All it cares about is the company’s cash flow available to distribute dividends or repay Debt, and Levered Free Cash Flow is much closer to that number.

So, if you’re looking for LBO candidates as part of a private equity case study, it might be helpful to screen companies by Levered Free Cash Flow.

That said, it’s not much better than the standard “Free Cash Flow” metric, which excludes Debt issuances and repayments, and standard FCF is easier to find and calculate.

In fact, the normal FCF metric might be better for screening LBO candidates because companies’ capital structures are wiped out and replaced in leveraged buyouts, so the post-transaction Debt repayment numbers will change anyway.

Here’s a comparison table:

Levered Free Cash Flow: Much Ado About Nothing?

In our view, you should never spend more than a few minutes thinking about Levered Free Cash Flow and the Levered DCF.

These methodologies are not useful in 99% of real-world situations, and you need to know about them mostly to answer possible interview questions about variations of the traditional DCF model.