Valuation foundations
From EBIT to unlevered free cash flow
What cash a business really generates for all its investors — and how to calculate it.
Learning objectives
- Explain why valuation uses free cash flow rather than net income
- Calculate NOPAT and unlevered free cash flow
- Explain how working capital affects cash flow
- Reconcile net income to unlevered free cash flow
A DCF values a business by the cash it can pay out to all its capital providers — lenders and shareholders — after funding the investment it needs to keep operating and growing. That is unlevered free cash flow (FCF).
We start from operating profit (EBIT), tax it as if the company had no debt, add back non-cash charges, and subtract the investment in fixed assets and working capital.
FCF = EBIT × (1 − tax rate) + D&A − Capex − ΔNWC
- EBIT × (1 − t)
- NOPAT: net operating profit after tax
- D&A
- depreciation & amortization — a non-cash expense deducted in EBIT, so added back
- Capex
- capital expenditure on fixed assets
- ΔNWC
- increase in net working capital (receivables + inventory − payables): cash tied up in operations
Why cash and not profit? Accounting profit records revenue when it is earned and spreads the cost of a machine over its life through depreciation. That is useful for measuring performance, but an investor can only be paid in cash. A company can report a healthy profit while its cash is absorbed by new equipment or by customers who have not yet paid. FCF corrects profit in both directions: it adds back depreciation (a cost with no cash leaving in the year) and deducts the cash actually spent on capex and working capital.
A reliable method, in the same order every time:
- Start from EBIT (operating profit, before interest).
- Deduct tax at the operating tax rate to get NOPAT.
- Add back non-cash charges — mainly D&A.
- Subtract capex.
- Subtract the increase in net working capital (or add a decrease).
The result is the cash the operations could hand to lenders and shareholders together, which is exactly the claim that enterprise value measures.
Interpreting FCF. Negative FCF is not automatically bad news. Take a fictional Riyadh logistics company expanding its fleet: EBIT SAR 40m, tax 20%, D&A 10m, capex 35m and a 12m build-up in working capital as new contracts start. NOPAT is 32.0m, but net reinvestment (capex − D&A + ΔNWC) is 37.0m, so FCF is -5.0m. Whether that destroys or creates value depends on the return those investments earn — which is why a DCF forecasts several years rather than valuing one year's figure.
Two practical signals: capex persistently below D&A suggests the asset base is shrinking (sustainable only briefly); FCF persistently far below NOPAT in a mature business suggests profit is not converting into cash. In the next lesson you will forecast each component from revenue, and later discount the stream at the WACC.
One year of free cash flow
Calculate the tax on EBIT (B9), NOPAT (B10) and unlevered free cash flow (B11) from the inputs above. Link every formula to the inputs. (Revenue is shown for context only.)
| A | B | |
|---|---|---|
| 1 | Inputs | |
| 2 | Revenue (for context) | 500,000.00 |
| 3 | EBIT | 75,000.00 |
| 4 | Tax rate | 20.0% |
| 5 | Depreciation & amortization | 20,000.00 |
| 6 | Capital expenditure | 30,000.00 |
| 7 | Increase in net working capital | 8,000.00 |
| 8 | ||
| 9 | Tax on EBIT | |
| 10 | NOPAT | |
| 11 | Unlevered free cash flow |
Check your understanding
During the year a company's receivables grow by 10,000 and nothing else in working capital changes. What is the effect on free cash flow?
Calculate
Challenge: a company reports net income of 52m after interest expense of 15m. The tax rate is 20% on all pre-tax profit, D&A is 20m, capex 30m and net working capital rose by 8m. What is unlevered free cash flow (in m)?
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