Do You Use Levered or Unlevered Free Cash Flow for DCF?

Discounted Cash Flow (DCF) valuation is a fundamental method for assessing the worth of businesses and assets. It determines an asset’s value from the present value of its anticipated future cash flows. This approach allows investors and analysts to estimate a company’s worth today, based on the money it is expected to generate over time. DCF analysis helps determine if an investment is worthwhile by providing a forward-looking perspective, relying on expectations of future performance.

Defining Unlevered Free Cash Flow

Unlevered Free Cash Flow (UFCF), also known as Free Cash Flow to the Firm (FCFF), represents the cash flow generated by a company’s core operations before debt payments. This metric reflects the cash available to all capital providers, including debt and equity holders. It is “unlevered” because it excludes the effects of financing decisions like interest expenses and debt repayments. This makes UFCF useful for comparing companies with different capital structures, providing an “apples-to-apples” view of their operational cash generation.

Calculating UFCF typically begins with Net Operating Profit After Tax (NOPAT). Non-cash expenses like depreciation and amortization are added back. Increases in net working capital are subtracted, as are capital expenditures (CapEx). The formula is: UFCF = EBIT × (1 – Tax Rate) + Depreciation & Amortization – Change in Working Capital – Capital Expenditures.

Defining Levered Free Cash Flow

Levered Free Cash Flow (LFCF), also known as Free Cash Flow to Equity (FCFE), represents the cash flow remaining after a company fulfills all its financial obligations, including interest and debt repayments. This cash flow is available only to equity holders. LFCF is “levered” because it directly incorporates the impact of the company’s debt structure and associated financial costs. It measures the cash shareholders could potentially receive through dividends, share buybacks, or reinvestment.

The calculation of LFCF usually starts with Net Income. Non-cash expenses like depreciation and amortization are added back, and changes in net working capital and capital expenditures are adjusted. A key distinction for LFCF is the inclusion of net debt repayments or proceeds. The formula for LFCF is: Net Income + Depreciation & Amortization – Change in Net Working Capital – Capital Expenditures + Net Borrowing. This metric is relevant for equity investors seeking to understand the cash available to them.

DCF Valuation Frameworks

Discounted Cash Flow analysis employs two primary frameworks: the Enterprise Value DCF and the Equity Value DCF. Each serves a distinct purpose by focusing on different aspects of a company’s total value. The fundamental difference lies in what is being valued and for which stakeholders the valuation is performed.

An Enterprise Value DCF determines the value of the entire company, including its equity and debt, before considering the capital structure. This valuation is relevant for potential acquirers interested in purchasing the whole business, as it represents the total value of operating assets. It provides a comprehensive view of the business’s worth, independent of its financing. The discount rate reflects the overall risk of the company’s operations and the cost of capital for all its funding sources.

Conversely, an Equity Value DCF focuses solely on valuing the equity portion of the company, which is the value attributable to shareholders. This framework is primarily used by stock investors interested in the value of the shares they own. It represents the residual value after all debt obligations have been accounted for. The discount rate reflects the risk specific to equity holders and their required rate of return.

Aligning FCF Type with DCF Model

The selection between unlevered and levered free cash flow is a key decision in DCF valuation, dependent on the specific framework and discount rate. Mismatching these components can lead to misvaluation. The consistency principle mandates that the cash flow being discounted must align with the capital providers whose returns are being measured.

Unlevered Free Cash Flow (UFCF) is the appropriate choice for an Enterprise Value DCF. Since UFCF represents cash flow available to all capital providers—both debt and equity holders—it must be discounted by the cost of all capital. The Weighted Average Cost of Capital (WACC) serves as this discount rate, reflecting the blended average cost of financing a company’s assets from all sources. WACC accounts for the after-tax cost of debt and the cost of equity, weighted by their proportions in the capital structure. This approach allows for valuing operating assets, suitable for comparing companies regardless of their financing mix.

Levered Free Cash Flow (LFCF) is used in an Equity Value DCF model. LFCF represents cash flow available exclusively to equity holders after all debt obligations, including interest and principal repayments, have been met. Therefore, it is appropriate to discount LFCF using the Cost of Equity, which is the return required by equity investors for the risk they undertake. The Cost of Equity is often derived using models like the Capital Asset Pricing Model (CAPM), considering the risk-free rate, market risk premium, and the company’s equity beta. This pairing ensures the valuation accurately reflects the value attributable to shareholders.

Key Considerations for DCF Application

Applying Discounted Cash Flow valuation effectively requires careful attention to several practical aspects influencing the model’s accuracy. Forecasting future free cash flows is a primary area and forms the foundation of the DCF model. Realistic assumptions are essential when projecting revenues, operating margins, capital expenditures, and changes in working capital for the explicit forecast period, typically five to ten years. These projections should consider industry trends, economic conditions, and the company’s strategic plans.

The terminal value calculation is another significant component, often representing a substantial portion of the total valuation. This value accounts for cash flows a company is expected to generate beyond the explicit forecast period, into perpetuity. Common methods include the perpetuity growth model, which assumes a constant growth rate for cash flows indefinitely, or the exit multiple method, which applies a multiple (like EV/EBITDA) to the last year’s projected metrics. The long-term growth rate in the perpetuity model should generally be modest, often below the expected long-term GDP growth rate.

Given the reliance on assumptions, conducting sensitivity analysis helps understand the robustness of the DCF model’s output. This process identifies which assumptions most significantly influence the final valuation and provides a range of possible values. The DCF model’s reliability depends on the quality and accuracy of underlying financial data, emphasizing the importance of using audited statements and sound judgment in projections.