3.7) DCF Analysis - Calculating Free Cash Flow Flashcards
- Why do you calculate Unlevered Free Cash Flow by including and excluding various items on the financial statements?
Unlevered FCF must capture the company’s core, recurring line items available to ALL investor groups. That’s because Unlevered FCF corresponds to Enterprise Value, which also represents the value of the company’s core business available to all investor groups. So, if an item is NOT recurring, NOT related to the company’s core business, or NOT available to all investor groups, you ignore it.
This rule explains why you ignore these items:
* Net Interest Expense – Only available to Debt investors.
* Other Income / (Expense) – Corresponds to non-core or non-operating Assets.
* Most non-cash adjustments besides D&A – They’re non-recurring.
* All Items in Cash Flow from Financing – They’re only available to certain investors.
* Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item.
Remember the general rule to calculate Unlevered FCF.
The key rule is: include only recurring items that are related to the company’s core business and that are available to all the investor groups.
- How does the Change in Working Capital affect Free Cash Flow, and what does it tell you about a company’s business model?
The Change in Working Capital tells you whether the company generates extra cash as it grows or whether it requires extra cash to support its growth. It’s related to whether a company records expenses and revenue before or after paying or collecting them in cash. For example, retailers tend to have negative values for the Change in Working Capital because they usually have to pay for Inventory before delivering it to customers. But subscription-based software companies often have positive values for the Change in Working Capital because they might collect cash from long-term subscriptions upfront and recognize it as revenue over time. The Change in WC could increase or decrease the company’s Free Cash Flow, but it’s rarely a major value driver because it’s fairly small for most companies.
- Should you add back Stock-Based Compensation to calculate Free Cash Flow? It’s a non-cash add-back on the Cash Flow Statement.
No! You should consider SBC a cash expense in the context of valuation because it creates additional shares and dilutes the existing investors. By contrast, Depreciation & Amortization relate to timing differences: the company paid for a capital asset earlier on but divides that payment over many years and recognizes it over time. Stock-Based Compensation is a non-cash add-back on the Cash Flow Statement, but the context is different: accounting rather than valuation. In a DCF, you should count SBC as a real cash expense or, if you count it as a non-cash add-back, you should assume additional shares by increasing the company’s diluted share count. Either way, the company’s Implied Share Price decreases. Many DCFs get this wrong because they use neither approach: they pretend that SBC is a non-cash add-back that makes no impact on the share count (wrong!).
- What’s the proper tax rate to use when calculating FCF – the effective tax rate, the statutory tax rate, or the cash tax rate?
The company’s Free Cash Flows should reflect the cash taxes it pays. So, it doesn’t matter which rate you use as long as the cash taxes are correct. For example, you could use the company’s effective tax rate (Income Statement Taxes / Pre-Tax Income) and then include an adjustment for Deferred Taxes. Or you could calculate and use the company’s “cash tax rate” and skip the Deferred Tax adjustments. You could even use the statutory tax rate and make adjustments for state/local taxes and other items to arrive at the company’s real cash taxes. It’s most common to use the effective tax rate and then adjust for the Deferred Taxes based on historical trends.
- How should CapEx and Depreciation change within the explicit forecast period?
Just like the company’s Free Cash Flow growth rate should decline in the explicit forecast period, the company’s CapEx and Depreciation, as percentages of revenue, should decrease.
High-growth companies tend to spend more on Capital Expenditures to support their growth, but this spending declines over time as they move from “growing” to “mature.” If the company’s FCF is growing, CapEx should always exceed Depreciation, but there may be a smaller difference by the end. CapEx should not equal Depreciation – even in the Terminal Period (again, assuming the company is still growing). That’s partially due to inflation (capital assets purchased 5-10 years ago cost less) and because Net PP&E must keep growing to support FCF Growth in the Terminal Period. If the company’s FCF stagnates or declines, then you might use different assumptions.
- Should you include inflation in the FCF projections?
In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for prices and salaries tend to be based on nominal figures. If you include inflation, you also need to forecast inflation far into the future and adjust all figures in your analysis. That’s rarely worthwhile because of the uncertainty and extra assumptions required.
- If the company’s capital structure is expected to change, how do you reflect it in FCF?
You’ll reflect it directly in a Levered DCF because the company’s Net Interest Expense and Debt principal will change over time. You’ll also change the Cost of Equity over time to reflect this. The changing capital structure won’t show up explicitly in the projections of an Unlevered DCF, but you will still reflect it with the Discount Rate – WACC will change as the company’s Debt and Equity levels change.
- What’s the relationship between subtracting an expense in the FCF projections and the Implied Equity Value calculation at the end of the DCF?
If you subtract a certain expense in FCF, then you should ignore the corresponding Liability when moving from Implied Enterprise Value to Implied Equity Value at the end.
For example, with U.S.-based companies, you normally subtract the Rental Expense on Operating Leases in the FCF projections because Rent is a standard operating expense. Therefore, you ignore the Operating Lease Liability in the Enterprise Value bridge at the end. But if you exclude or add back the Rental Expense in FCF, you do the opposite and subtract the Operating Lease Liability in the bridge. This rule also explains why you subtract Debt in the bridge for an Unlevered analysis: UFCF excludes the corresponding Interest Expense on the Debt.
- How do Net Operating Losses (NOLs) factor into Free Cash Flow?
You could set up an NOL schedule and apply the NOLs to reduce the company’s cash taxes, also factoring in NOL accruals if the company earns negative Pre-Tax Income. If you do this, you don’t need to count the NOLs in the Implied Enterprise Value → Implied Equity Value bridge at the end. However, it’s far easier to skip that separate schedule and add NOLs as non-operating Assets in the bridge. Beyond the extra work, one problem with the first approach is that the company may not use all of its NOLs by the end of the explicit forecast period! Yes, you could account for this by calculating the Terminal Value of the NOLs, discounting it to Present Value, and adding it to the other components, but it’s extra work for almost no benefit.
- How do pensions factor into the Free Cash Flow calculations?
There are different components of the Pension Expense, including the Service Cost, the Interest Expense, the Expected Return on Plan Assets, the Amortization of Net Losses or Gains, and Other Adjustments. The Service Cost is an operating expense and should be deducted in both types of Free Cash Flow (and then added back as a non-cash expense). The company incurs this expense regardless of the funded status of its plan because it’s based on the employee count, average salary, years of employment, etc., and so it is considered operational. In an Unlevered DCF, you exclude the non-operational components: the Interest Expense, Expected Return on Plan Assets, and Amortization of Net Losses or Gains.
You should also subtract the company’s contributions into the plan because those are also operational (they do not depend on the plan’s funded status). Then, if the pension plan is unfunded (Pension Liabilities > Pension Assets), you subtract this unfunded portion when moving from Implied Enterprise Value to Implied Equity Value. You may also multiply it by (1 – Tax Rate) if pension contributions are tax-deductible. In a Levered DCF, the main difference is that you deduct all expenses associated with the pension plan (everything mentioned above, including company contributions) because there is no “bridge” at the end. So, all associated expenses must be deducted within Levered FCF.
- Should you ever include items such as asset sales, impairments, or acquisitions in FCF?
For the most part, no. You certainly shouldn’t make speculative projections for these items – they are all non-recurring. If a company has announced plans to sell an asset, make an acquisition, or record a write-down in the near future, then you might factor it into FCF for that year. And if it’s an acquisition or divestiture, you’ll have to adjust FCF to reflect the cash spent or received, and you’ll have to change the company’s cash flow after the deal takes place.
- How should the Operating and Finance Lease expenses factor into the Unlevered FCF calculations?
It depends on how you’re treating these items in the TEV bridge and the WACC calculation. We recommend deducting the full expenses associated with all Leases directly within UFCF and then not subtracting the corresponding Liabilities in the bridge and not counting them as a source of capital within WACC. That is fairly simple for U.S.-based companies and requires a small deduction for the Interest element of the Finance Lease expense (if the company has Finance Leases). For IFRS-based companies, you’ll have to deduct the Interest element for both lease expenses within UFCF. In both cases, should add back only the D&A on owned assets, not the Lease D&A (remember that the Interest/Depreciation split is artificial – the company still pays a cash lease expense regardless of the lease type).
If you want to do extra work, you could take the opposite approach and add back or exclude the full Lease expense and then subtract the Lease Liabilities in the bridge and include them in WACC. If you do that, you’ll have to add back the Rental Expense for U.S.-based companies and the Depreciation element of Finance Leases when calculating “Lease-Adjusted EBIT” so that UFCF is a higher number that excludes the full lease expense (and ignore this Depreciation element in the D&A add-back). And you’ll have to deduct the Change in the PV of Lease Liabilities each year to reflect the cash cost of new leases. For IFRS-based companies, you’ll have to add back the Depreciation element of both lease expenses so that “Lease-Adjusted EBIT” excludes the full expense (and ignore this portion in the D&A add-back).
- How does the Unlevered Free Cash Flow calculation differ for U.S. vs. non-U.S. companies?
It’s mostly a question of how you’re treating Operating and Finance Leases, which was explained in the previous question. It’s easiest to deduct the full Lease Expense from all lease types in the UFCF calculation. For IFRS-based companies, that means finding and deducting the Interest element of the lease expense for both types and adding back only D&A on owned assets. But you could use the opposite approach as well (described above). Non-U.S. companies also tend to disclose less information, especially in emerging and frontier markets, so you may have to settle for simpler UFCF projections as well.
