5.3 Valuation and DCF Analysis - DCF Analysis: Calculating Free Cash Flow

11. Should you ever include items such as asset sales, impairments, or acquisitions in FCF?

For the most part, no. You certainly shouldn't make speculative projections for these items - they are all non-recurring, so it's not correct to forecast them as if they were recurring, predictable items. If a company has announced plans to sell an asset, make an acquisition, or record a write-down in the near future, then you might factor it into FCF for that year. And if it's an acquisition or divestiture, you'll have to adjust FCF to reflect the cash spent or received, and you'll have to change the company's revenue and expenses in future periods.

8. What's the relationship between including an income or expense line item in FCF and the Implied Equity Value calculation at the end of the DCF?

If you include an income or expense in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end (and vice versa for items you include). For example, if you capitalize the company's operating leases and count them as a Debt-like item at the end, then you should exclude the rental expense from FCF, making it higher. This rule also explains why, in an Unlevered DCF analysis, you have to factor in Cash and Debt when moving to the Implied Equity Value: You've excluded the corresponding items on the Income Statement (Interest Income and Interest Expense).

6. Should you reflect inflation in the FCF projections?

In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for prices and salaries tend to be based on nominal figures. If you reflect inflation, then you also need to forecast inflation far into the future and adjust all figures in your analysis. This extra effort is probably not worth it because of the uncertainty and extra work.

5. How should CapEx and Depreciation change over the explicit forecast period?

Just like the company's Free Cash Flow growth rate should decline over the explicit forecast period, the company's CapEx and Depreciation should also decline. High-growth companies tend to spend more on Capital Expenditures to support their growth, but this spending declines over time as the companies move from "growth" to "maintenance." If the company's FCF is growing, CapEx should always exceed Depreciation, but there may be less of a difference by the end. If the company's FCF is growing, CapEx should never EQUAL Depreciation. That's partially due to inflation (capital assets purchased 5-10 years ago cost less back then), and partially because if you're assuming FCF growth in the Terminal Period, Net PP&E needs to keep growing to support it. If you're assuming that the company's FCF declines or stagnates, then you might use different assumptions.

3. Should you add back Stock-Based Compensation to calculate Free Cash Flow? It's a non-cash add-back on the Cash Flow Statement.

No! SBC is not a real non-cash expense in the context of valuation because it creates additional shares and dilutes the existing investors. By contrast, Depreciation & Amortization relate to timing differences: The company paid for something earlier on, but recognizes it over several years. It's true that Stock-Based Compensation is a non-cash expense on the Cash Flow Statement, but the context is different: Accounting rather than valuation. The financial statements reflect the true impact of SBC because the company's diluted share count goes up as a result. In a DCF, you should either count SBC as a real cash expense or include it as a non-cash add-back and reflect the additional shares, which will reduce the company's Implied Share Price. Most DCF analyses get this completely wrong because they don't use either approach: They pretend that SBC is a normal non-cash charge that makes no impact on the share count.

2. How does the Change in Working Capital affect Free Cash Flow, and what does it tell you about a company's business model?

The Change in Working Capital tells you whether the company generates more cash than expected as it grows, or whether it requires more cash to fuel that growth. It's related to whether a company records items before or after paying or collecting them in cash. For example, retailers tend to have negative values for the Change in Working Capital because they must pay for Inventory upfront before they can sell products. But subscription-based software companies often have positive values for the Change in Working Capital because they collect cash from long-term subscriptions upfront and recognize the revenue over time. The Change in WC could reduce or increase the company's Free Cash Flow, but it's rarely a major value driver because it tends to be fairly small for most companies.

4. What's the proper tax rate to use when calculating FCF - the effective tax rate, the statutory tax rate, or the cash tax rate?

The company's Free Cash Flows should reflect the cash taxes it pays. So it doesn't matter which rate you use as long as the cash taxes are correct. For example, you could use the company's effective tax rate (Income Statement Taxes / Pre-Tax Income), and then factor in Deferred Taxes within the non-cash adjustments. So if a company pays more or less in taxes than what it has recorded on its Income Statement, you could adjust afterward. Or you could calculate the company's "cash tax rate" and skip the Deferred Tax adjustments. You could even use the statutory tax rate and make adjustments for state/local taxes and other items to arrive at the company's real cash taxes. It's most common to use the effective tax rate and then adjust for Deferred Taxes based on historical trends.

10. How does the Pension Expense factor into Free Cash Flow?

There are several different components of the Pension Expense, including the Service Cost, the Interest Expense, the Expected Return on Plan Assets, the Amortization of Net Losses or Gains, and Other Adjustments. Most of those count as operating expenses and should be reflected in the company's Free Cash Flow. In an Unlevered DCF, you should exclude the Interest Expense and Expected Return on Plan Assets within the Pension Expense and then subtract the Unfunded portion of the Pension Obligation when moving from Implied Enterprise Value to Implied Equity Value. Some companies embed these items within Operating Expenses on the Income Statement, so you may have to review the filings to calculate EBIT properly. You may have to multiply the Unfunded Pension by (1 - Tax Rate) as well, though the treatment differs under U.S. GAAP and IFRS and in different countries.

1. WHY do you calculate Unlevered Free Cash Flow by excluding and including various items on the financial statements?

Unlevered FCF must capture the company's core, recurring items that are available to ALL investor groups. That's because Unlevered FCF corresponds to Enterprise Value, which also represents the value of the company's core business that's available to all investor groups. So if an item is NOT recurring, NOT related to the company's core business, or NOT available to all investor groups, you leave it out. This rule explains why you exclude all of the following items: • Net Interest Expense - Only available to Debt investors. • Other Income / (Expense) - Corresponds to non-core-business Assets. • Most non-cash adjustments besides D&A - They're non-recurring. • The Cash Flow from Financing section - They're available only to certain investors. • Most of Cash Flow from Investing - Only CapEx is a recurring, core-business item.

9. How do Net Operating Losses (NOLs) factor into Free Cash Flow?

You could set up an NOL schedule and use them to reduce the company's cash taxes, also factoring in accruals if the company ever records negative Pre-Tax Income. If you do this, then you don't need to count them in the Implied Enterprise Value -> Implied Equity Value calculation at the end. However, it's far easier to skip that separate schedule and add NOLs as a non-core-business Asset in this calculation at the end. Beyond the extra work, one problem with the first approach is that you may not use all the NOLs by the end of the explicit forecast period!

7. If the company's capital structure is expected to change, how do you reflect it in FCF?

You'll reflect it directly in a Levered DCF because the company's Net Interest Expense and Debt Repayments will change over time. It won't show up explicitly in Unlevered FCF, but you will still reflect it in the analysis by changing the Discount Rate over time - WACC changes as the company's Debt and Equity levels change. And in a Levered FCF, Cost of Equity will change because additional Debt increases the Cost of Equity and less Debt reduces it.