1 Free Cash Flow Overview When you re valuing a company with a DCF analysis, you need to calculate their Free Cash Flow (FCF) to figure out what they re worth. While Free Cash Flow is simple in theory, in practice it has generated more questions on the BIWS site than almost any other topic. I m going to cover 7 key points about FCF here: 1. What "Free Cash Flow" actually means, and why we use it rather than EBITDA, EPS, or other profitability metrics in a DCF. 2. An outline of how to transform a Cash Flow Statement into a Free Cash Flow calculation. 3. What you do with Working Capital line items, what you include and exclude, and why you add or subtract different items in those calculations. 4. Unlevered vs. Levered Free Cash Flow, and why we normally use Unlevered FCF in a DCF. 5. How to project Free Cash Flow over a 5-year period in a DCF. 6. How to put all these pieces together and calculate FCF via different formulas. 7. Lingering / common questions on how to calculate FCF in a DCF analysis. What Free Cash Flow Means and FCF vs. EBITDA vs. EPS Free Cash Flow means: How much cash is this company s core business generating, on a recurring, predictable basis? Many companies define Free Cash Flow as: Cash Flow from Operations minus Capital Expenditures (CapEx) (Yes, this is a simplified definition we ll get into the more detailed ones in a bit). We define it that way because those items: 1. Are related to the company s core business Cash Flow from Operations reflects the cash they earn, and CapEx reflects how much cash they need to spend to grow that business. 2. Recur on a predictable basis Unlike items related to acquisitions or equity/debt financing, for example, most mature companies earn a predictable amount in cash and spend a predictable amount on CapEx. Free Cash Flow is different from EBITDA and Earnings Per Share (EPS) for the following reasons: EBITDA is an accounting metric and excludes Taxes, Capital Expenditures, and changes to items like Inventory, Accounts Receivable and Accounts Payable so it is not the best representation of how much real cash a company generates.
2 Earnings Per Share (EPS) includes non-cash charges such as Depreciation & Amortization, and excludes changes in balance sheet items like Inventory, Accounts Receivable, and Accounts Payable. It also excludes CapEx, so it s even less accurate for measuring cash flow than EBITDA. EBITDA and EPS are useful for comparing different companies to one another, but they are less useful for establishing how much in after-tax cash flow a company generates on its own. Here s a table that lays out how all these metrics stack up: FCF EBITDA EPS Stands For: Free Cash Flow Earnings Before Interest, Earnings Per Share Taxes, Depreciation & Amortization How to Calculate It: Varies based on whether Levered or Unlevered (see next sections); basically Cash Flow from Operations CapEx Operating Income (EBIT) + Depreciation & Amortization + Potentially Other Non-Cash and One- Time Charges Net Income / Shares Outstanding What Does It Mean? How much real cash flow does this company generate from its business on a recurring, predictable basis? Levered Yes; Unlevered No How does this company s operating income, before taxes, interest, and (some) non-cash charges, compare to other companies? No How does this company s after-tax earnings compare to other companies? Includes Interest Yes Income / (Expense)? Includes Taxes? Yes No Yes Includes Non-Cash Only includes tax-impact No (Depending on the Yes Charges? of non-cash charges calculation) Includes Changes Yes No No in Working Capital? Includes CapEx? Yes No No Includes Mandatory Debt Repayment? Levered Yes; Unlevered No No No EBITDA and EPS are useful when comparing different companies because EBITDA adjusts for different tax rates, different non-cash charges, capital structures, and so on, and gives you a more normalized metric, and EPS is useful because it is quick to calculate (that s one of its few redeeming qualities). However, neither one is a particularly accurate measure of how much cash a company really generates because both metrics exclude major items like CapEx. Return to Top.
3 From the Cash Flow Statement to Free Cash Flow If you re just sticking to a basic definition of Free Cash Flow, you can re-use the company s Cash Flow Statement to calculate it here s an example from Steel Dynamics, a company in the industrials sector: Cash Flow from Operations is always your starting point because these items are all related to the company s core business and are recurring and predictable. Here, we start with Net Income but in an Unlevered Free Cash Flow Calculation (keep reading) you would use Operating Income * (1 Tax Rate) to exclude Interest Income and Interest Expense. Next up is the Cash Flow from Investing Section: You only include Capital Expenditures here because they are the only item that s recurring, predictable, and related to the company s core business. Acquisitions are certainly not predictable, and investing in commercial paper, financing leases, and so on, are not core business-related. Even something liking selling assets (the proceeds from the asset sales show up here) is also non-recurring, so you leave it out.
4 If you have specific reason to believe that one of these items IS going to be recurring (e.g. the company states explicitly that it plans to keep selling off $100 of assets each year) then maybe you can leave it in. Otherwise, you only count CapEx from this section of the Cash Flow Statement. Finally, the easy part Cash Flow from Financing: In an Unlevered Free Cash Flow calculation, you always leave out all the items here because: 1. Dividends, issuing or paying off debt, issuing or repurchasing stock, and so on are not related to the company s core business, but rather to its investors and/or capital structure. 2. These items are all optional a company doesn t technically need to issue dividends, but it certainly needs to keep spending on CapEx if it wants its business to grow. In a Levered Free Cash Flow calculation, you would count mandatory debt repayments here because that s a required, recurring use of cash and you do care about the company s capital structure there. Now that we ve been through that sketch, let s look at the most common questions on FCF and variations such as Unlevered and Levered FCF. Return to Top. What s the Deal with Working Capital? This point probably causes more confusion than anything else specifically, what do you include in this section and what do you exclude? The real answer: Whatever the company you re analyzing does in its filings. There s little-to-no consistency in what you find in this section, and companies often include very different items depending on what they consider related to their business.
5 Generally you should include: Current Assets except for Cash & Cash-Equivalents (and Investments, Marketable Securities, etc.) you keep those out because you calculate how they change at the bottom of the cash flow statement, so you d be double-counting if you did it here as well. Current Liabilities except for Debt and debt-related items. You should also exclude Deferred Tax Assets and Deferred Tax Liabilities from this section most of the time since companies track changes to those right above in the section with non-cash charge adjustments. Additionally, you may also include some Long-Term Assets and some Long-Term Liabilities here IF they are related to the company s core business operations. Here s an example for Steel Dynamics: A few things to note here: They include Income Taxes Receivable and Income Taxes Payable but not Deferred Income Tax Assets or Liabilities because those are not related to the core business operations. They arise from different Depreciation methods, M&A deals, net operating losses, and so on. They don t explicitly include Long-Term Assets here but Other Assets could easily refer to Long- Term Assets we have no way of knowing unless they clarify that in the filings. Aside from that, you see fairly standard items like Accounts Receivable, Inventory, Accounts Payable, Accrued Expenses, etc. As always, if an asset goes up it drains cash flow and if an asset goes down it increases cash flow and vice versa for liabilities.
6 So, what should you say in an interview if you re asked about Working Capital when calculating Free Cash Flow? Generally, you include Current Assets except for Cash and Deferred Tax Assets, and Current Liabilities except for Debt and Deferred Tax Liabilities, and when an asset goes up, it increases cash flow, and when it goes down it reduces cash flow; the opposite applies for liabilities. Common examples for Current Assets are Accounts Receivable, Inventory and Prepaid Expenses; common examples of Current Liabilities are Accounts Payable and Accrued Expenses. Don t even mention Long-Term Assets and Liabilities because it will lead to even more in-depth questions about what might go there keep it simple unless they ask for more. Return to Top. Unlevered Free Cash Flow vs. Levered Free Cash Flow Here s the difference between these two: Unlevered Free Cash Flow: Excludes the impact of interest income, interest expense, and mandatory debt repayments and is therefore capital-structure neutral. In other words, the company s value does not depend on how much cash and debt it has. Levered Free Cash Flow: Includes the impact of interest income, interest expense, and mandatory debt repayments. In other words, the company s value does depend on how much cash and debt it has. Unlevered FCF is also known as Free Cash Flow to Firm (FCFF) and Levered Free Cash Flow is also known as Free Cash Flow to Equity (FCFE). Of these two metrics, Levered Free Cash Flow is closer to how much real cash a company generates but normally in a DCF we use Unlevered Free Cash Flow anyway. Why? Because most of the time in investment banking / private equity / hedge funds / equity research / asset management we care about a company s core business value, not the value that comes from its cash and debt. Running Unlevered DCF analyses also makes it far easier to compare the outputs between different companies and different industries, so in 99% of cases you will see Unlevered FCF used in the real world.
7 The other big difference is that if you use Unlevered FCF (or Free Cash Flow to Firm), you calculate the company s Enterprise Value but with Levered FCF (or Free Cash Flow to Equity), you calculate the company s Equity Value. We have received A LOT of questions on this, so here s how you can think about it using a funnel structure: Think of cash flow as a way to pay investors in the company. At the top, before you take out interest expense and debt repayments, that cash flow is available to everyone both equity and debt investors. What metric represents both equity and debt investors? That s right, Enterprise Value. After you ve got this cash flow available to everyone, you then pay debt investors by making the required interest payments and principal repayments to them. Now that they ve been paid, that remaining cash flow is only available to equity investors, and you can pay those equity investors by issuing dividends or repurchasing shares from them. Since this cash flow is only available to equity investors, when you use it in a DCF you calculate the company s Equity Value. Here s how the formulas for Unlevered FCF (FCFF) and Levered FCF (FCFE) differ: Levered Free Cash Flow: Net Income + Non-Cash Charges Increase in Working Capital CapEx Mandatory Debt Repayments
8 Unlevered Free Cash Flow: Operating Income * (1 Tax Rate) + Non-Cash Charges Increase in Working Capital CapEx We add back non-cash charges because we want to include the tax effects of those charges, but not the charges themselves. What does Increase in Working Capital mean? Working Capital in a DCF is (usually) defined as Current Assets, Excluding Cash and Deferred Tax Assets, minus Current Liabilities, Excluding Debt and Deferred Tax Liabilities. So when Working Capital is increasing, that means that the Current Assets portion is growing more quickly than Current Liabilities and remember from your basic accounting that if an asset goes up, cash flow goes down. Therefore, if the company is increasing its current assets more quickly than its current liabilities, it is spending cash and this number will be a negative to reflect that. If, on the other hand, it s increasing its current liabilities more quickly, this number will be a positive to show that its Working Capital is actually generating cash. Return to Top. Projecting Unlevered Free Cash Flow Over a 5-Year Period If you already have a 3-statement projection model for the company you re analyzing, this part s easy just pull in all the data from there. If not, normally you start with revenue growth and operating margin (or, COGS as a % of revenue and Operating Expenses as a % of revenue and subtract those to calculate Operating Income and the margin) and make everything else in the analysis flow from those. Generally, you assume that a company s revenue growth will slow over time and that as it grows bigger, it also needs to spend more to sell more products, support its customers, hire employees, and so on. Here are the assumptions we ve used for Steel Dynamics: Revenue grows at 20% the first year, declines by 5% each year for 2 years, then declines by 2%, and then declines by 3% in the final year. This is based on historical revenue growth of 50%+ and 25%+. Large companies simply do not grow at those rates forever, and growth declines over time.
9 Operating Margin is 5.4% each year, based on the 3-year historical average. You could make an argument for decreasing this percentage over time due to greater economies of scale, but it s better to be conservative in a DCF and use historical averages. One of the most common mistakes in a DCF is to assume inflated growth numbers, or overly optimistic expense ratios which is why we recommend a conservative approach. Here s what the Revenue and Operating Income look like: Then, assuming that you re calculating Unlevered Free Cash Flow, you apply the company s standard, effective tax rate to that Operating Income number. Do not just subtract their normal taxes take the standard tax rate (30%? 35%? 40%?) and apply it the Operating Income numbers. In this case, we know from their historical statements that Steel Dynamics has an effective tax rate of 38%: After you subtract taxes from Operating Income, you arrive at NOPAT (Net Operating Profit After Tax), which is similar to Net Income but excludes Interest Income and Interest Expense because we re projecting Unlevered Free Cash Flow here. Next, you need to add back non-cash expenses. The most common ones are Depreciation & Amortization and Stock-Based Compensation, but you see plenty of other ones in this section as well: Impairment Charges Often set to $0 in future periods since they re non-recurring Deferred Income Taxes % of revenue or average historical numbers Gains / (Losses) on Asset Sales Often set to $0 in future periods since they re non-recurring
10 Amortization of Intangibles You should pull these from the company s filings, since they always include longer-term projections (do a search for amortization ) Goodwill Impairment Often set to $0 in future periods since it s non-recurring Here s what this section looks like for Steel Dynamics: Note that Depreciation & Amortization, Equity-Based Compensation, and Deferred Income Taxes are all projected as percentages of revenue. In a more complex model you might have separate schedules for these, but in a quick DCF this approach is fine. Next, we need to subtract the Increase in Working Capital and Capital Expenditures. If a company needs more Working Capital funds to run its business and to pay for items like Inventory that drains its cash flow. When we need more money to run the business, we have less cash overall. Capital Expenditures (CapEx) refer to investments in factories, equipment, land, and anything else that lasts for over a year. We subtract CapEx because it doesn t show up on the Income Statement but it is a real expense that reduces the cash balance:
11 I ve broken out the Changes in Working Capital section line-by-line, which is unusual I did that mainly for teaching purposes here. Normally in a DCF, you would just show the Net Decrease / (Increase) in Working Capital line at the bottom. Both of these numbers are, once again, percentages of revenue. I used the historical average for Working Capital, but for CapEx I chose 3% rather than using an average. Why? Historically, it jumped around and was significantly higher in Year 0 than in Years 1 and 2. If we just averaged CapEx as a % of Revenue there, it might have been too high due to the higher percentage in Year 0 (we probably should have done the same thing for Deferred Income Taxes, but skipped it here). Here s what the entire 5-year projected period looks like:
12 In this case, Unlevered Free Cash Flow = Operating Income * (1 Tax Rate) + Non-Cash Charges Increase in Working Capital CapEx. Return to Top. Formulas for Calculating Free Cash Flow Since we began teaching these courses, we ve probably gotten 200+ questions on various formulas floating around to calculate Free Cash Flow. Most of these formulas are equivalent but they may look different initially you just have to think through them and see what they really mean. For example: I ve heard this formula for Levered Free Cash Flow before: Net Income + Non-Cash Charges Increase in Working Capital CapEx Mandatory Debt Repayment. But then some people say that it s just Cash Flow from Operations CapEx Mandatory Debt Repayment. Which one is right? They re the same, because Cash Flow from Operations is Net Income + Non-Cash Charges Increase in Working Capital. For your reference, here are several common formulas for both types of Free Cash Flow. Unlevered Free Cash Flow (Free Cash Flow to Firm): Operating Income * (1 Tax Rate) + Non-Cash Charges Increase in Working Capital CapEx NOPAT + Non-Cash Charges Increase in Working Capital CapEx (Revenue COGS Operating Expenses) * (1 Tax Rate) + Non-Cash Charges Increase in Working Capital CapEx (NOTE: For this to work you must include those non-cash charges in COGS and Operating Expenses) Cash Flow from Operations + Interest Expense * (1 Tax Rate) Interest Income * (1 Tax Rate) CapEx You ll see some definitions that start with EBITDA but I prefer not to do that because it complicates how you calculate Taxes and Non-Cash Charges. Levered Free Cash Flow (Free Cash Flow to Equity): Pre-Tax Income * (1 Tax Rate) + Non-Cash Charges Increase in Working Capital CapEx Mandatory Debt Repayments Cash Flow from Operations CapEx Mandatory Debt Repayments
13 Net Income + Non-Cash Charges Increase in Working Capital CapEx Mandatory Debt Repayments Unlevered Free Cash Flow Interest Expense * (1 Tax Rate) + Interest Income * (1 Tax Rate) Mandatory Debt Repayments It s not a great idea to memorize all these formulas because you could calculate both metrics in many ways focus on understanding the concept and you ll be able to walk them through everything above easily. Return to Top. Lingering Questions on Free Cash Flow Q: Wait, so why isn t Levered Free Cash Flow used as frequently? A: Because we mostly care about a company s Enterprise Value and Levered FCF gives us Equity Value plus, Levered DCF analyses tend to place too much emphasis on a company s capital structure in determining its value. Plus, you have the problem of having to project interest expense and debt repayments going forward, which can be difficult depending on the company. So overall it is both easier and more useful to use Unlevered FCF. Q: How can I tell whether a non-cash charge should be added back in the non-cash charge add-back section? A: It depends on whether or not it has already been included in Operating Income (for an Unlevered DCF) or in Net Income (for a Levered DCF). If it has been included in those, it will impact Cash Flow from Operations and so you need to add it back. If it has not been included in those, you do not add it back (for example, something like a one-time charge that is included between Operating Income and Pre-Tax Income when you re calculating Unlevered FCF). Q: How can I tell whether or not something goes in the Working Capital section? A: When in doubt, always go by what a company has done historically in its filings. You can follow the general rules above if it is for a fictitious company or something without filings (e.g. a case study in an interview). Q: What s the difference between EBIT and Operating Income? Do we add back different items to calculate each of those?
14 A: They should be the same in theory. But some people will add back items like stock-based compensation to one or both of them, so you need to be careful when looking at the figures. For purposes of a DCF analysis, you want both EBIT and Operating Income to include the impact of non-cash charges such as Depreciation & Amortization because they reduce the company s taxes. Q: What if Free Cash Flow is negative? Or Operating Income? A: Then you really shouldn t be using a DCF to value the company or you need to project the company over a much longer period until it starts generating positive Operating Income or Free Cash Flow (i.e. for a pharmaceuticals company where it might take years to generate revenue). Q: What about additional debt that the company borrows? How does that factor in? A: If you have reason to believe that they will definitely borrow a certain amount on a recurring basis each year in the future, then you should count that and add it when calculating Levered FCF, but still exclude it from Unlevered FCF. I did not mention this point above because most of the time you don t know what a company s plans are with respect to additional debt so it can be dangerous to include it in the calculation. Q: Why do you exclude cash and debt from Working Capital? A: Because neither one is related to the company s business operations they re just financing choices. Also, you calculate the ending cash number at the bottom of the Cash Flow Statement so if you also counted it in Changes in Working Capital you d be double-counting. Changes in debt belong in the Cash Flow from Financing section, not Changes in Working Capital, so that is why you exclude debt from the calculation. Q: What about deferred tax assets and liabilities? A: Generally you leave these out of the Working Capital section because they re accounted for elsewhere in Cash Flow from Operations, namely in the section above for non-cash adjustments. The logic is similar to excluding cash and debt: these items relate to a company s chosen method of depreciation, M&A activity, and use of net operating losses, so they are not part of their core business operations. Q: Wait a minute, why do you add back Deferred Income Taxes in Unlevered FCF? Operating Income and Pre-Tax Income are much different, so how can you assume that the deferred tax portion will be the same?
15 A: This is a good point, and in a more complex DCF you would adjust for this here, we ve skipped over it because it s a quick analysis. Most likely we would lower the percentage above since Year 0 seemed unusually high, percentage-wise. Anything Else? Ask away! We have a few hundred questions just on the DCF analysis within the Breaking Into Wall Street lessons already, and the more the merrier. Return to Top.
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