This guide explains what unlevered free cash flow (UFCF) is and its role in business valuation. We will look at how these unlevered free cash flows are used in DCF valuations as well as how to calculate them. Here are some key takeaways about UFCF:
Unlevered free cash flows are commonly used in Discounted Cash Flow (DCF) Valuations. When we do a DCF analysis correctly, we end up with the business’ enterprise value. Enterprise value is the value of the business without giving consideration to its capital structure. In order to calculate the enterprise value of a business, we need to account for the right cash flows—cash flows available to all capital providers.
Unlevered free cash flows are cash flows available to all debt and equity providers after operating expenses have been paid, working capital has been funded, and capital expenditures have been taken into account.
When two companies are compared to each other, the enterprise values are often used.
This is because we can better compare companies to one another when we look past their capital structure. Some businesses are financed more with debt and others more so with equity. These decisions surrounding how to raise capital are part of a longer-term strategy and not directly related to a DCF valuation.
If we look past this at the cash flows themselves, we can more usefully compare companies to one another without letting one company’s debt structure confuse the comparison. Some companies may have high interest expenses because they have chosen to finance growth with debt. It’s confusing to compare those companies to others with little or even no interest expense. Unlevered free cash flows help us to look past a business’ capital structure so that we can make more meaningful comparisons.
Now that we understand the purpose for using unlevered free cash flows, we will look at how to calculate the UFCF a business has. There are actually a few different ways to calculate a business’ unlevered free cash flows. Here is a step-by-step process commonly used:
An important note here is to understand working capital and how it impacts unlevered free cash flows.
If the net working capital goes up, then that means there will be less unlevered free cash flows. This is because more money is required to fund the core operations of the business. Conversely, if net working capital goes down, then it represents an inflow of cash because it means that it takes less time for the company to get paid in full for products sold or services rendered.
So far we’ve seen why unlevered free cash flows are used to calculate the enterprise value of a business. The idea is that we want to see the cash flows available to all capital providers.
In a DCF valuation, two of the biggest mistakes made are using the wrong cash flows or the wrong discount rate. When using the unlevered free cash flows, we would want to use the weighted average cost of capital (WACC) as the discount rate.
The rationale here is that if we’re trying to determine the enterprise value of the business (it’s total value without consideration to its capital structure) we want to use the unlevered free cash flows (which are available to all capital providers) and discount them back in time at the weighted average cost of capital—which also gives consideration to all capital providers.
Using the WACC for the discount rate keeps our assumptions consistent between our numerator and denominator. To learn more about how to calculate a DCF valuation, we recommend this guide.