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Advanced DCF Modeling

Choosing the Right Cash Flow

You already know that a company's value is tied to its future cash flows. But which cash flows? The answer depends on what you're trying to value: the entire company or just its equity. This distinction leads us to two key metrics: unlevered and levered free cash flow.

Unlevered Free Cash Flow (FCFF) is the cash available to all capital providers, both debt and equity holders. It's the cash flow generated by the business before accounting for any debt payments.

FCFF=EBIT(1−T)+D&A−CapEx−ΔNWCFCFF = EBIT(1-T) + D\&A - CapEx - \Delta NWC

Levered Free Cash Flow (FCFE), on the other hand, is the cash available only to equity holders after all debt obligations have been met. It represents the cash that could theoretically be paid out as dividends.

FCFE=Net Income+D&A−CapEx−ΔNWC+ΔNet DebtFCFE = Net\ Income + D\&A - CapEx - \Delta NWC + \Delta Net\ Debt

Most valuation models start with FCFF to calculate the enterprise value of the company. It gives a cleaner picture of the core business operations, independent of how the company is financed. The impact of debt is captured later, in the discount rate.

The Art of the Discount Rate

Forecasting cash flows is only half the battle. We need to discount those future flows to their present value, and for that, we need an appropriate discount rate. When using FCFF, the standard is the (WACC). WACC represents the blended cost of all the capital a company uses—both debt and equity.

WACC=(EV×ke)+(DV×kd×(1−T))WACC = (\frac{E}{V} \times k_e) + (\frac{D}{V} \times k_d \times (1-T))