Value Investing News - Free Cash Flow vs Unlevered Free Cash Flow - Comments

I tried to explain this same concept to J. Ponzio

Chungst — Mon, 16 Jun 2008 18:37:59 -0400

"Basically, I have taken operating cash flow and subtracted out capital expenditures. However, I have started reading about unlevered free cash flows and I was wondering if my approach is really sound."

The goal of financial analysis is to also look at the economics, not just the accounting numbers (Joe P. still uses accounting numbers in his articles). There are three distinct ways a company can control key assets: via outright acquisitions, via true operating leases, and via sub-contracting. Let's take the case of two companies in the same industry and one uses debt financing to acquire the necessary assets and the other uses operating leases. In the first company, the company shows debt on the balance sheet while the second company does not (true operating leases, FASB #13, are off balance financings). If the these companies are identical except for the financings used, then the difference in accounting results is due to financial engineering (and tax codes). The "economics" of these companies didn't really change despite different accounting numbers. That's why a company that uses operating leases generally has higher ROE but comparable ROIC when the operating leases are normalized.

The prior example focuses the reader on the economics. Now, let's say you have a company that has used debt to acquire the asset versus another company that uses cash to purchase the asset. If both companies generated the same amount of "FCF," it's clear based on the economics that the first company's FCF is divided between the debtholders and equityholders. In the second company, all the FCF goes to the equityholders. Therefore debt reduces FCF to equityholders and thus depress stock price.

"Are there any drawbacks to using unlevered free cash flows for running DCF valuations?"

No, if you account for the debt (and other balance sheet adjustments). The enterprise value of a firm is the sum of its market value of debt plus its market value of equity less surplus cash. If you used unlevered FCF to arrive at the enterprise value, you now have to subtract the debt to arrive at the value that is left for equityholders. Think of it this way, moneys for debtholders are moneys not available for equityholders.

For more information, please see http://pages.stern.nyu.edu/~adamodar/ and see link for spreadsheets.

Also see 1986 Berkshire Hawathway's annual report where Buffett writes about the "Cash Flow Fallacy" in the appendix. Understanding "the economics" versus accounting numbers is key.

Re: Fully Taxed EBIT

George — Tue, 10 Jun 2008 00:06:41 -0400

I think the fully taxed EBIT is just = EBIT - (EBIT x r) where r is the full tax rate. I believe 33% is often used as the average full corporate tax rate in the US.

Fully Taxed EBIT

ZVIADK — Mon, 09 Jun 2008 10:25:24 -0400

How the Fully Taxed EBIT can be calculated? I heard it is better to use Fully Taxed EBIT in Free Cash Flow calculations, because it adjusts against the changes in taxed amount every year.

Importance of DCF Valuation

ZVIADK — Mon, 09 Jun 2008 10:02:54 -0400

I agree that DCF model is too flawed and nobody beats market based only on DCF method, but in corporate banking, when you do really need to value the company, to find out what is the approximate value of it, what method is best to use then? On what you should rely if not a DCF valuation model?

Thanks.

Unlevered free cash flow

spreadsheet — Sat, 02 Feb 2008 02:08:50 -0500

It all depends on what you are comparing the fcf to. If its levered, then you should compare it to the market cap. If unlevered, then you should compare it to the enterprise value. One way to kind of keep it straight is to remember that the equity is the lowest piece on the cap structure totem pole so the free cash flow should be AFTER the debtholders receive their interest expense. Now, most people will use a dcf model to value the equity and they don't really care about the debt per say (in which case you would use a levered free cash flow). I don't use any sort of DCF model and haven't used one since college...too flawed. In fact, I don't know anyone in the industry that uses them. Quick! Name one person who's consistently beaten the market with a DCF model....no one comes to my mind either. Where the unlevered fcf comes into use is when you looked at a free cash flow yield-type analysis. Basically, unlevered free cash flow divided by EV is one way. The other way (and the way I recommend) is levered free cash flow divided by Market cap. Using the levered free cash flow takes into account the LEVEL of interest vis-a-vis the debt load (some companies like DPZ have very high leverage but have a great interest rate). Companies that can issue low-cost debt should be rewarded, all else equal. (Probably doesn't need to be said but companies that are highly levered can be dangerous). Hope that helps. Email me if you have any questions: admin@valueinvestingplanet.com

Free Cash Flow vs Unlevered Free Cash Flow

George — Wed, 30 Jan 2008 23:50:45 -0500

I recent started thinking about how I use free cash flows in my discounted cash flow models as a result of reading this thread about stock screens. In the past, I have tended to make very few adjustments to my free cash flow calculations. Basically, I have taken operating cash flow and subtracted out capital expenditures. However, I have started reading about unlevered free cash flows and I was wondering if my approach is really sound. It is my understanding that unlevered free cash flows are equal to operating cash flow - capital expenditures - (net interest income x (1 - tax rate). What are your thoughts on this FCFu? I guess this adjusts for the tax benefits that come from debt interest. This FCFu should also probably excludes exceptional items, deferred income tax benefits and tax benefits from stock options. Are there any drawbacks to using unlevered free cash flows for running DCF valuations?