Unlevered free cash flow (“UFCF”) is the cash flow available to all providers of capital, including debt, equity, and hybrid capital. A business or asset that generates more cash than it invests provides a positive FCF that may be used to pay interest or retire debt (service debt holders), or to pay dividends or buy back stock (service equity holders).
Most DCF analyses use annual projection intervals. Theoretically, the shorter the projection interval, the more accurate the DCF valuation. However, projecting smaller intervals usually requires several additional assumptions that may more than offset the additional accuracy. Certain situations (for example, seasonal businesses) require adjustments to projection intervals to more accurately reflect the timing of UFCF. Additionally, using an annual projection interval may require a shorter stub period for the first interval (to reflect that a deal would close mid-year, for example).
UFCFs should be projected to the time when the business attains maturity and experiences steady-state growth and profitability (growth and profitability that can be sustained over a long period of time without substantial new investment). Most DCF analyses use 5 or 10-year projection periods. Projecting cash flows over a longer period is inherently more difficult. A shorter projection period increases the accuracy of the projections, but also places greater emphasis on the contribution of terminal value (TV) to the total valuation.
Calculation of Unlevered Free Cash Flow
|Amortization of non-deductible goodwill
|Taxes on EBITA (EBITA × projected tax rate)
|Unlevered net income
|D&A and other non-cash charges affecting EBIT (excl. non-deductible goodwill amortization)
|Changes in deferred taxes
|Increase in non-cash working capital
|Unlevered free cash flow (UFCF)
Exhibit A – Unlevered Free Cash Flow Calculation
The following spreadsheet shows how to calculate unlevered free cash flow. The blue inputs are hard-coded for simplicity, but would normally be linked to items on the income and cash flow statements.
Income Statement and Cash Flow Items
Download our operating model template to see how to project income statement items over the projection period. The following exhibit discusses the various inputs necessary to calculate EBIT.
Exhibit B – Income Statement and Cash Flow Items
|Client projections, research reports, and historical sales growth
|Client projections, research reports, and historical gross profit margins
|Client projections, research reports, and historical EBIT margins
|Client projections, research reports, and historical tax rates
|Client projections, research reports, and historical depreciation as a % of sales, relationship to CapEx, latest gross PP&E divided by an estimated average useful life
|Client projections, research reports, and historical amortization amount or as a % of sales
|Client projections, research reports, and historical CapEx as a % of sales
Balance Sheet Items
Download our operating model template to see how to project balance sheet working capital items over the projection period. Non-cash working capital excludes cash and cash equivalents, short-term borrowings, and the short-term portion of long-term debt. Non-cash working capital should be estimated by separately projecting its various components when possible. As a surrogate, non-cash working capital may be projected as a percent of sales. Use the following equations to separately project working capital items:
Exhibit C – Working Capital Equations
Accounts Receivable Days = (Accounts Receivable ÷ Sales) × 365 Days
Inventory Days = (Inventory ÷ COGS) × 365 Days
Accounts Payable Days = (Accounts Payable ÷ COGS) × 365 Days