Q&A: DCF valuation – leveraged or unleveraged free cash flow?

Hello! I would like to understand from a fundamental point of view why DCF uses unleveraged free cash flow (UFCF) streams instead of leveraged free cash flow (LFCF).

From the point of view of ease of calculation, the fact that the UFCF does not take into account the capital structure, as well as disputes over whether to take into account the mandatory payments or not – this is understandable, but still, I would like to hear an answer in your style – complete and fundamental.

From AP

February 2021

The Footnotes Analyst

Both approaches can be used to produce a valid DCF valuation. Equity value equals …

  • The present value of the unleveraged cash flow (UFCF or enterprise cash flows) discounted at WACC less the value of non-common share claims such as debt; or
  • The present value or leveraged free cash flow (LFCF or equity cash flows) discounted at the cost of equity.

As long as the underlying assumptions are consistent both approaches should give the same answer. The reason why many prefer the enterprise (or UFCF) approach is that it is easier to apply and, as a consequence, less prone to error. Here are some of the specific factors:

Forecasting debt flows: Equity free cash flow is enterprise flow plus the cash flow related to debt finance (and other debt like claims such as pensions or environmental liabilities). This means that these debt flows must be forecast – not just the interest payments but also any new debt raised and debt repayments. Interest payment forecasted would also need to take into account changes when debt is refinanced, such as due to the redemption of a fixed rate bond paying a high rate, Simplifications could be used such as assuming that debt increases in line with the growth in the business but overall forecasting these flows is challenging. For the enterprise FCF approach all one needs is the fair value of debt at the valuation date.

Discount rate and changes in leverage: The cost of equity used in an equity free cash flow valuation will need to vary each year if leverage changes. Only if the value of debt relative to the value of equity remains constant would the cost of equity not need to be amended. This is not to say that WACC may not have to change as well – changes in underlying business risk over time and potentially (depending on the tax system) changes in leverage can also impact WACC. However, the effects of these on WACC are likely to be smaller and less likely to matter in practice.

Non-core assets: An enterprise FCF approach is easier to apply if there are investments or other non-core assets to incorporate, which can be simply left out of the present value calculation and separately added in at their (estimated) fair values. For an equity FCF approach (at least one based only on equity flows) the cash flow contribution of these assets to the overall equity flow would need to be forecast.

Dilutive options: If an entity has a more complex capital structure, such as having outstanding share warrants, then these can be more easily included in an enterprise flow approach. For equity free cash flow, the impact of these instruments needs to be forecast based on the expected change in the share count, with the optionality of this dealt with using scenarios. For an enterprise approach the fair value of these instruments can simply be deducted in the bridge from present value of UFCF to equity value.

This is not to say that the unlevered or enterprise flow approach is easy – clearly there are many forecasting and computational challenges. However, all of these challenges are present for equity flows plus the additional ones identified above.