Unlevered free cash flow

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Unlevered free cash flow
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Unlevered free cash flow (UFCF), also called free cash flow to the firm (FCFF) - is the cash a business generates from its operations after paying taxes and after funding the investment it needs to keep running and growing, but before any payments to lenders. Aswath Damodaran describes it as "a cash flow after taxes and reinvestment needs but before any debt payments"[1]. It is the money that could, in principle, be handed out to everyone who financed the company: shareholders, bondholders, banks, preferred stockholders.

"Unlevered" is the important word. The figure is computed as if the company had no debt at all. Interest is not deducted, and the tax bill is the one the firm would pay on its operating profit alone. Two companies with identical factories, customers and margins will report the same UFCF even if one is funded entirely by equity and the other carries a heavy loan book. That makes the measure the natural input for enterprise valuation, where the whole business is valued first and the claims of the different capital providers are split up afterwards.

Background

The idea that a firm is worth the present value of its after-tax operating cash flows goes back to the capital structure work of Franco Modigliani and Merton Miller in 1958. Their valuation expression discounted after-tax operating earnings minus reinvestment at the cost of capital, and it did not care how the business was financed[1]. Free cash flow to the firm is the practical descendant of that formula.

Practitioners took it up in the 1980s. Alfred Rappaport's Creating Shareholder Value (1986) pushed managers to judge strategies by the discounted free cash flow they would produce rather than by accounting earnings per share[2]. Consulting firms followed. McKinsey's Valuation handbook, first published in 1990 and now authored by Tim Koller, Marc Goedhart and David Wessels, built its "enterprise DCF" model around free cash flow discounted at the weighted average cost of capital[3]. Today it's standard material in the CFA Program curriculum. A survey of professional analysts quoted there found that 86.9% of those using discounted cash flow analysis rely on a discounted free cash flow model, and that FCFF models are used roughly twice as often as FCFE models[4].

Formula of Unlevered free cash flow

There is no single "correct" starting point. The same number can be reached from operating profit, from net income or from the cash flow statement. All roads should lead to the same place.

From EBIT

The most common version starts with operating profit (income from operations, EBIT):

\[ UFCF = EBIT \times (1 - t) + D\&A - CapEx - \Delta NWC \]

where:

  • \( EBIT \times (1-t) \) is net operating profit after tax (NOPAT), with t the marginal or normalised tax rate,
  • \( D\&A \) is depreciation and amortization and other non-cash charges,
  • \( CapEx \) is capital expenditure on fixed and intangible assets,
  • \( \Delta NWC \) is the increase in net working capital (receivables plus inventory minus payables, excluding cash and debt).

Damodaran writes the same thing more compactly as after-tax operating income minus net capital expenditure (CapEx minus depreciation) minus the change in non-cash working capital[1].

From net income

Net income has already had interest deducted, so the after-tax interest must be added back:

\[ FCFF = NI + NCC + Int \times (1 - t) - FCInv - WCInv \]

NCC stands for non-cash charges, FCInv for fixed capital investment and WCInv for working capital investment. This is the notation used in the CFA Institute reading on free cash flow valuation[5].

From cash flow from operations

Under US GAAP interest paid sits inside operating cash flow, and the working capital change has already been captured there:

\[ FCFF = CFO + Int \times (1 - t) - FCInv \]

Under IFRS companies may classify interest paid as operating or financing, so the analyst has to check where it went before adding anything back. Get it wrong and interest is either counted twice or not at all[5].

From EBITDA

\[ FCFF = EBITDA \times (1 - t) + D\&A \times t - FCInv - WCInv \]

The term \( D\&A \times t \) is the depreciation tax shield. It's easy to forget.

Unlevered vs levered free cash flow

The difference lies in who gets paid first. Levered free cash flow, usually called free cash flow to equity (FCFE), is what remains after lenders have received interest and after the company has borrowed or repaid debt. The CFA reading links the two in one line[5]:

\[ FCFE = FCFF - Int \times (1 - t) + Net\ borrowing \]

Feature Unlevered FCF (FCFF) Levered FCF (FCFE)
Belongs to All capital providers Common shareholders only
Interest Not deducted Deducted (after tax)
Debt issued or repaid Ignored Added / subtracted
Discount rate WACC Cost of equity
Result of discounting Enterprise value Equity value directly
Sensitivity to financing decisions Low High

Which to pick? FCFF tends to be more practical when leverage is expected to change a lot, for instance in a leveraged buyout or a company paying down acquisition debt, because forecasting net borrowing year by year is messy. FCFE can be simpler for banks and insurers, where debt is raw material rather than financing. With consistent assumptions both routes should give the same equity value.

Use in DCF valuation

UFCF is the cash flow behind the enterprise version of discounted cash flow valuation, one of the main valuation methods used in equity research and M&A work.

Step 1: forecast UFCF

Analysts usually build an explicit forecast for 5 to 10 years, driven by revenue growth, operating margin, tax rate and reinvestment needs. This is ordinary forecasting, with all the problems that brings.

Step 2: discount at WACC

Because UFCF belongs to all investors, it is discounted at a rate reflecting all of them: the weighted average cost of capital. The tax benefit of debt is not in the cash flow; it enters through the after-tax cost of debt inside WACC[1]. An alternative that keeps the tax shield in the cash flows is the adjusted present value method.

Step 3: terminal value

Nobody forecasts year by year forever. After the explicit period, the business is assumed to grow at a constant rate g, and the remaining cash flows are collapsed into a single terminal value using the constant-growth formula associated with Myron Gordon[6]:

\[ TV_n = \frac{UFCF_{n+1}}{WACC - g} = \frac{UFCF_n \times (1+g)}{WACC - g} \]

Damodaran sets two conditions on this stable-growth model: g cannot exceed the growth rate of the economy, and the reinvestment assumed in the cash flows has to be consistent with that growth[7]. A firm cannot grow at 3% forever while reinvesting nothing.

The firm value is then:

\[ EV = \sum_{t=1}^{n} \frac{UFCF_t}{(1+WACC)^t} + \frac{TV_n}{(1+WACC)^n} \]

Step 4: from enterprise value to equity value

Enterprise value covers the whole operating business. To get to what shareholders own, subtract the value of non-equity claims and add non-operating assets:

\[ Equity\ value = EV - Debt + Cash - Preferred\ stock - Minority\ interests \]

Lease liabilities, unfunded pension deficits and similar debt-like items are subtracted too, if they were treated as financing when UFCF was calculated. Cash not needed in operations and investments in associates are added. Dividing by the diluted number of shares (often computed with the treasury stock method) gives value per share, which can be compared with the market price.

Example of Unlevered free cash flow

The following example is hypothetical. Company and numbers are invented for illustration; amounts in EUR million.

Alder Components has revenue of 500 this year. Management expects growth of 8%, 7%, 6%, 5% and 4% over the next five years. Other assumptions: EBIT margin 15%, tax rate 25%, D&A 4% of revenue, capital expenditure 5.5% of revenue, net working capital at 12% of revenue (so ΔNWC = 12% of the revenue increase). WACC is 9%, long-term growth 2.5%. Net debt is 150 and there are 40 million shares.

Year 1 2 3 4 5
Revenue 540.0 577.8 612.5 643.1 668.8
EBIT (15%) 81.0 86.7 91.9 96.5 100.3
Tax on EBIT (25%) 20.3 21.7 23.0 24.1 25.1
NOPAT 60.7 65.0 68.9 72.4 75.2
+ D&A 21.6 23.1 24.5 25.7 26.8
− CapEx 29.7 31.8 33.7 35.4 36.8
− ΔNWC 4.8 4.5 4.2 3.7 3.1
UFCF 47.8 51.8 55.5 59.0 62.1
Discount factor at 9% 0.9174 0.8417 0.7722 0.7084 0.6499
Present value 43.9 43.6 42.9 41.8 40.4

The present values of the five forecast years add up to 212.6.

Terminal value at the end of year 5:

\[ TV_5 = \frac{62.1 \times 1.025}{0.09 - 0.025} = \frac{63.65}{0.065} \approx 979.3 \]

Discounted back five years: 979.3 × 0.6499 ≈ 636.4.

Enterprise value = 212.6 + 636.4 = 849.0. Equity value = 849.0 − 150 = 699.0, or roughly €17.5 per share.

Notice something? About 75% of the enterprise value comes from the terminal value. That is typical, not unusual, and it explains why analysts argue so much about two inputs.

A quick cross-check from net income. Suppose year 1 interest expense is 9.0. Net income = (81.0 − 9.0) × 0.75 = 54.0. Then FCFF = 54.0 + 21.6 + 9.0 × 0.75 − 29.7 − 4.8 = 47.85, exactly the unrounded EBIT-route figure (60.75 + 21.6 − 29.7 − 4.8). Same cash flow, different door.

How fragile is the 849? A small sensitivity analysis of enterprise value (rounded):

WACC \ g 2.0% 2.5% 3.0%
8% 937 1,006 1,089
9% 801 849 905
10% 698 734 774

Moving WACC by one percentage point and g by half a point produces a range from 698 to 1,089. Since net debt is fixed at 150, equity value swings even more in relative terms: from 548 to 939.

Common adjustments

Raw accounting numbers seldom go straight into a UFCF model. Typical clean-ups include:

  • Stock-based compensation (SBC). SBC is a non-cash charge, so many data providers add it back like depreciation. Damodaran argues against this: employee options and restricted shares are a real cost of paying staff, and adding them back inflates cash flow while the dilution is ignored[8]. The consistent choices are to treat SBC as a cash-like expense, or to add it back and then count all future dilution in the share count. Not both, and not neither.
  • Leases under IFRS 16. Since annual periods beginning on 1 January 2019, IFRS 16 requires lessees to recognise a right-of-use asset and a lease liability for almost all leases longer than 12 months[9]. Rent disappears from operating expenses and is replaced by depreciation and interest. EBIT and EBITDA rise, and so does the measured UFCF, because part of the lease payment now looks like financing. If lease payments are excluded from UFCF, the lease liability must be subtracted as debt when moving to equity value, and WACC should reflect lease financing. Mixing the two treatments is a classic error.
  • One-off items. Restructuring charges, litigation settlements, asset sale gains and impairments distort the base year. They are normally removed from the forecast, but if "one-offs" appear every year they are probably part of the business.
  • Operating vs excess cash. Interest income on surplus cash belongs outside UFCF; the cash itself is added at the equity bridge.
  • Acquisitions. Serial acquirers spend heavily on purchases recorded outside CapEx. Ignoring them makes free cash flow look far better than the growth plan really allows.

Koller, Goedhart and Wessels recommend reorganising the balance sheet and income statement into operating and financing items before computing free cash flow, precisely so that each of these items ends up on one side only[3].

Advantages of Unlevered free cash flow

  • Independent of capital structure: companies with very different debt levels can be compared on operating performance.
  • Fits enterprise valuation and M&A work, where a buyer often plans to replace the existing financing anyway.
  • Hard to manipulate through accounting choices on revenue recognition or accruals, because it is anchored in cash, not profit.
  • Changes in leverage go into the discount rate, not into every year's cash flow, which keeps the forecast simpler[1].
  • Underlies ratios such as the free cash flow yield on enterprise value and links naturally to economic value added, which uses the same NOPAT and invested capital.
  • Works for companies that pay no dividends, where a free cash flow approach is more meaningful than a dividend discount model[4].

Limitations of Unlevered free cash flow

  • Terminal value dominance. In the example three quarters of the value sat in the terminal value. Small changes to g or WACC move the answer by hundreds of millions.
  • WACC is an estimate, not an observation. It depends on beta, the equity risk premium, target leverage and the cost of debt. Each input is debatable. The formula also blows up as g approaches WACC.
  • Forecasting risk. Margins, capital intensity and working capital are projected years ahead. Optimistic hockey-stick forecasts are common.
  • Lumpy CapEx. A single year of heavy investment can make UFCF negative for a healthy, growing company. Negative free cash flow is not automatically bad news.
  • Ignores financing reality. A company with strong UFCF can still default if its debt maturities come due at the wrong moment. Lenders look at levered measures and coverage ratios for that reason.
  • Constant WACC assumption. A single discount rate implicitly assumes a stable debt ratio. When leverage changes a lot, APV is usually cleaner[7].
  • Definitional drift. Data providers, companies and analysts compute "free cash flow" in different ways (SBC, leases, acquisitions). Two published UFCF figures for the same company can be far apart.

Related approaches

  • Levered free cash flow (FCFE) - discounted at the cost of equity to value shares directly.
  • Adjusted present value - unlevered cash flows discounted at the unlevered cost of equity, with tax shields valued separately.
  • Dividend discount model - values only the cash actually paid to shareholders.
  • Economic value added and residual income models - give the same value as DCF under consistent assumptions, but show where value is created year by year.
  • Sum of the parts valuation - separate UFCF models for each division, added up.
  • Multiples such as EV/EBITDA or EV/adjusted EBITDA - quick market-based checks on a DCF result.
  • Project cash flow and net present value - the same logic applied to a single investment instead of a whole company.

References

Footnotes

  1. ↑ Damodaran A., Valuation Approaches and Metrics: A Survey of the Theory and Evidence, Stern School of Business, 2006, pp. 26-27
  2. ↑ Rappaport A., Creating Shareholder Value: The New Standard for Business Performance, Free Press, 1986
  3. ↑ Koller T., Goedhart M., Wessels D., Valuation: Measuring and Managing the Value of Companies, 5th edition, John Wiley & Sons, 2010
  4. ↑ CFA Institute, Free Cash Flow Valuation, refresher reading, 2025, Introduction (citing Pinto, Robinson and Stowe 2019)
  5. ↑ CFA Institute, Free Cash Flow Valuation, refresher reading, 2025, Summary
  6. ↑ Gordon M.J., Dividends, Earnings, and Stock Prices, The Review of Economics and Statistics, 1959
  7. ↑ Damodaran A., Valuation Approaches and Metrics: A Survey of the Theory and Evidence, 2006, p. 27; Damodaran A., FCFF Valuation Models, lecture notes
  8. ↑ Damodaran A., Investment Valuation, 3rd edition, John Wiley & Sons, 2012
  9. ↑ IFRS Foundation, IFRS 16 Leases, effective for annual reporting periods beginning on or after 1 January 2019
Unlevered free cash flow — recommended articles
Levered free cash flow — WACC — Valuation of companies — Adjusted present value — Free cash flow yield — Cash flow analysis — Optimal capital structure
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