Projection Period
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
| EBIT |
| (+) |
Amortization of non-deductible goodwill |
| EBITA |
| (-) |
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 |
| (-) |
Capital expenditures |
| (-) |
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.
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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
|
|
| Sales |
|
Client projections, research reports, and historical sales growth |
|
- Sales growth should converge to a long-term, sustainable rate.
- The projection period should extend until the business reaches a steady state.
|
| Gross Profit |
|
Client projections, research reports, and historical gross profit margins |
|
- Projected profitability should be based on expectations about the future rather than historical performance.
|
| EBIT |
|
Client projections, research reports, and historical EBIT margins |
|
- EBIT should include recurring other income/expenses unless assets generating such income/expenses are added/subtracted in the calculation of net debt.
- EBIT should exclude goodwill amortization per SFAS 142 if CY2001 or an earlier year is used to arrive at EBIT margin
|
| Tax Rate |
|
Client projections, research reports, and historical tax rates |
|
- Use best judgment to determine the appropriate tax rate (e.g. marginal vs. effective) based on the circumstances and available information.
|
| Depreciation |
|
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 |
|
- Often projected as a % of sales for convenience.
- Need to consider the relationship between depreciation and CapEx (they should converge somewhat by the end of the projection period).
- Obtain depreciation from the cash flow statement rather than the income statement.
|
| Amortization |
|
Client projections, research reports, and historical amortization amount or as a % of sales |
|
- Amortization should exclude goodwill amortization per SFAS 142 unless projected EBIT also includes goodwill amortization.
|
| CapEx |
|
Client projections, research reports, and historical CapEx as a % of sales |
|
- CapEx should converge toward depreciation over the projection period as the business reaches a mature, steady state.
|
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
