1. Unlevered Free Cash Flow Calculations
And now for the moment you've all been waiting for.
Let's talk about how to actually calculate unlevered free cash flows.
There are multiple different ways to calculating unlevered free cash flows,
but the first method we will take a look at
is what we call the EBIT or NOPAT method. This is the most
common way to calculate unlevered free cash flows.
We begin with EBIT or earnings before interest in taxes,
this is also usually synonymous with operating income.
From EBIT, we take out taxes to calculate NOPAT or net operating profit
after tax. One thing to note is that interest expense is usually tax
deductible, however, we are not removing it from EBIT when we calculate
NOPAT. So we are effectively assuming if the firm has no debt and
is 100% equity financed. From NOPAT, we need to adjust for any non
cash expenses with depreciation and amortization typically being the largest
adjustment. So we add those back because they're non cash expenses,
but they reduced EBIT and consequently NOPAT. We then need to deduct out
any reinvestment back in the business, like capital expenditures and changes
in working capital. We deduct increases in networking capital,
but we add back decreases in networking capital.
Then we arrive at unlevered free cash flow.
The cash flow is free since the company has met its reinvestment needs,
again, CapEx and working capital. Here are two other methods we can use
to calculate unlevered free cash flows, the net income method. In this method,
we obviously begin with net income, since net income is after interest expense
is deducted, it is considered a levered metric.
Therefore, in order to convert this levered metric into an unlevered metric,
we add back the after tax interest expense,
in other words, because interest expense is usually tax deductible,
it reduces net income by interest expense times one minus the tax rate.
Therefore, we add back the same calculation to convert net income
to be unlevered, and just like in the NOPAT or EBIT method,
we add back depreciation, we subtract CapEx and account for changes in working
capital. There's also the EBITDA method. However, when calculating unlevered
free cash flows directly from EBITDA, we will need a detailed tax schedule
in order to determine unlevered cash taxes. We cover this calculation in
more detail in our DCF valuation modeling course,
otherwise, the calculation is directionally the same as the EBIT method.
Now, let's take a look at how we can calculate
all of these different methodologies in our Excel file.
2. Let's practice!