{"id":24241,"date":"2022-01-25T18:23:36","date_gmt":"2022-01-25T23:23:36","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/?post_type=biws_kb&#038;p=24241"},"modified":"2025-01-29T23:29:18","modified_gmt":"2025-01-30T04:29:18","slug":"levered-free-cash-flow","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/valuation\/levered-free-cash-flow\/","title":{"rendered":"Levered Free Cash Flow and the Levered DCF: The Most Useless Concepts in Valuation? [PLEASE SEE THE IMPORTANT NOTE BELOW THE VIDEO]"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">Levered Free Cash Flow and the Levered DCF: The Most Useless Concepts in Valuation?<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/levered-free-cash-flow\/#What_Changes_in_a_DCF_Based_on_Levered_Free_Cash_Flow\">What Changes in a DCF Based on Levered Free Cash Flow?<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/levered-free-cash-flow\/#US_GAAP_vs_IFRS_Issues_in_the_Levered_Free_Cash_Flow_Calculation\">U.S. GAAP vs. IFRS Issues in the Levered Free Cash Flow Calculation<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/levered-free-cash-flow\/#Will_a_DCF_Based_on_Levered_Free_Cash_Flow_Produce_Equivalent_Results\">Will a DCF Based on Levered Free Cash Flow Produce Equivalent Results?<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/levered-free-cash-flow\/#Is_Levered_Free_Cash_Flow_Useful_for_Anything_What_About_the_Levered_DCF\">Is Levered Free Cash Flow Useful for Anything? What About the Levered DCF?<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/levered-free-cash-flow\/#Levered_Free_Cash_Flow_Much_Ado_About_Nothing\">Levered Free Cash Flow: Much Ado About Nothing?<\/a><\/li><\/ul><\/nav><\/div>\n\n<blockquote><p><strong>Levered Free Cash Flow Definition:<\/strong> Levered Free Cash Flow (LFCF), also known as Free Cash Flow to Equity (FCFE), equals a company\u2019s Net Income to Common + Depreciation &amp; Amortization +\/- Deferred Taxes +\/- Change in Working Capital \u2013 Capital Expenditures +\/- Net Debt Borrowings.<\/p><\/blockquote>\n<p><strong>IMPORTANT NOTE:<\/strong> The video here has a calculation error with the Levered FCF numbers. Please go by the screenshots and written guide on this page and the Excel file provided here. These have all been corrected. Unfortunately, YouTube does not let us &#8220;replace&#8221; or &#8220;correct&#8221; the video, so we can&#8217;t fix this issue without deleting and re-uploading the entire video and losing all the comments and data.<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-25689 size-full\" title=\"Levered Free Cash Flow Formula\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074804\/Levered-Free-Cash-Flow-Image-01.jpg\" alt=\"Levered Free Cash Flow Formula\" width=\"1038\" height=\"515\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074804\/Levered-Free-Cash-Flow-Image-01.jpg 1038w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074804\/Levered-Free-Cash-Flow-Image-01-300x149.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074804\/Levered-Free-Cash-Flow-Image-01-1024x508.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074804\/Levered-Free-Cash-Flow-Image-01-768x381.jpg 768w\" sizes=\"(max-width: 1038px) 100vw, 1038px\" \/><\/p>\n<div class='code-block code-block-2' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/04\/24164120\/adv-fm-tile.png\" alt=\"PowerPoint Pro\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Financial Modeling for Investment Banking With <strong>BIWS Core Financial Modeling<\/strong><\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Become a financial modeling pro<\/h4>\n              <p>158 videos, detailed written guides, Excel files, quizzes, and more<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 10+ detailed global case studies<\/h4>\n            <p>These include both the theory and the practical applications<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Prepare for your internship or full-time job<\/h4>\n            <p>Gain the skills you need to \u201chit the ground running\u201d on Day 1\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/core-financial-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Core-Financial-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div><\/div>\n\n<h3><strong>Video Table of Contents:<\/strong><\/h3>\n<p><strong>2:10:<\/strong> Part 1: Basic Definition of Levered FCF and Excel Demo<\/p>\n<p><strong>5:10:<\/strong> Part 2: Changes Required in a Levered DCF Analysis<\/p>\n<p><strong>10:44:<\/strong> Part 3: U.S. GAAP vs. IFRS Differences for Levered FCF<\/p>\n<p><strong>12:53:<\/strong> Part 4: Why the Levered and Unlevered DCF Are Not Equivalent<\/p>\n<p><strong>16:57:<\/strong> Part 5: Is Levered FCF Ever Useful?<\/p>\n<p><strong>19:05:<\/strong> Recap and Summary<\/p>\n<p>Although we always recommend using <a href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/unlevered-free-cash-flow\/\" target=\"_blank\" rel=\"noopener\">Unlevered Free Cash Flow<\/a> in a <a href=\"https:\/\/www.mergersandinquisitions.com\/dcf-model\/\" target=\"_blank\" rel=\"noopener\">DCF model<\/a>, there are other approaches as well.<\/p>\n<p>The one that generates the most questions and confusion is a <em>Levered DCF<\/em> based on Levered Free Cash Flow, also known as Free Cash Flow to Equity (FCFE).<\/p>\n<p>The basic difference is that Levered Free Cash Flow represents <strong>the cash flow available only to the <em>common shareholders<\/em> in the company<\/strong> rather than all the investors.<\/p>\n<p>In other words, it <strong>deducts<\/strong> payments to the debt investors (lenders), preferred stock investors, and any other investor groups <strong>beyond<\/strong> the common shareholders.<\/p>\n<p>Normally, when you value a public company, you\u2019re trying to estimate its implied share price, or how much the company\u2019s shares <em>should be worth<\/em>.<\/p>\n<p>Based on that, you might think that Levered FCF sounds more appropriate.<\/p>\n<p>After all, since the goal of a valuation is to estimate the company\u2019s implied share price, shouldn\u2019t you use a methodology that is based on <em>only<\/em> the common shareholders?<\/p>\n<p><strong>The short answer is that while Levered Free Cash Flow may seem more appropriate initially, setting up a Levered DCF requires additional work and substantial changes to all parts of the analysis, and it produces less consistent results than the Unlevered DCF \u2013 so it is rarely worth the time and effort.<\/strong><\/p>\n<h2><span class=\"ez-toc-section\" id=\"What_Changes_in_a_DCF_Based_on_Levered_Free_Cash_Flow\"><\/span><strong>What Changes in a DCF Based on Levered Free Cash Flow?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Since the entire analysis is now based on <strong>Equity Value<\/strong> and the <strong>common shareholders<\/strong>, almost every step in the process changes:<\/p>\n<p><strong>1) Use Cost of Equity for the Discount Rate, Not WACC<\/strong> \u2013 Since Levered FCF is available only to the equity investors, you use the Cost of Equity for the Discount Rate since it represents only the equity investors.<\/p>\n<p><strong>2) Subtract the Net Interest Expense and Add\/Subtract Net Borrowings<\/strong> \u2013 These items all affect the cash flow to equity investors, so you must factor them in. Effectively, you start with Net Income to Common rather than <a href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/nopat\/\" target=\"_blank\" rel=\"noopener\">NOPAT<\/a> and also include changes in the company\u2019s Debt principal.<\/p>\n<p><strong>NOTE:<\/strong> There is some disagreement about what to add and subtract, with the main options being \u201call Debt issuances and repayments,\u201d \u201cjust the repayments,\u201d and \u201cjust the mandatory repayments.\u201d<\/p>\n<p><strong>3) Calculate Terminal Value with P \/ E or Equity Value-Based Multiples<\/strong> \u2013 You\u2019re considering only equity investors, so <a href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/dcf-terminal-value\/\" target=\"_blank\" rel=\"noopener\">Terminal Value<\/a> calculated with the Multiples Method should use an Equity Value-based multiple.<\/p>\n<p><strong>4) Calculate the Implied Equity Value Directly at the End<\/strong> \u2013 You don&#8217;t need <a href=\"https:\/\/breakingintowallstreet.com\/kb\/equity-value-enterprise-value\/how-to-calculate-enterprise-value\/\" target=\"_blank\" rel=\"noopener\">a &#8220;bridge&#8221; between Equity Value and Enterprise Value<\/a> because the Levered DCF does not produce the Implied Enterprise Value. Instead, adding the PV of each Levered Free Cash Flow to the PV of the Terminal Value produces the Implied Equity Value directly.<\/p>\n<p><strong>5) Reflect the Items Formerly in the Bridge in the Levered Free Cash Flow<\/strong> \u2013 So, you need to factor in the tax savings from NOLs, Interest Income and Interest Expense, Preferred Dividends, the entire Pension Expense, and more.<\/p>\n<p>You must also <a href=\"https:\/\/www.mergersandinquisitions.com\/lease-accounting\/\" target=\"_blank\" rel=\"noopener\">deduct the <em>entire<\/em> Lease Expense<\/a> regardless of the accounting system. And you have to include Dividends from Equity Investments, adjustments for Non-Cash Interest, and anything else that affects the items in the TEV bridge of an Unlevered DCF.<\/p>\n<p>These changes may sound simple, but they\u2019re actually quite complicated \u2013 especially items #2 and #5.<\/p>\n<p>The problem is that you can\u2019t just assume simple, constant numbers for the company\u2019s Net Interest Expense, Debt issuances, and Debt repayments.<\/p>\n<p>Instead, you need to:<\/p>\n<ol>\n<li>Start with the company\u2019s <strong>scheduled<\/strong> Debt repayments, as disclosed in its filings.<\/li>\n<li><strong>Project<\/strong> the Debt issuances such that the company\u2019s capital structure stays about the same, accounting for the fact that its Equity Value will change over time. You can estimate the final-year Debt percentage by dividing the final Debt balance by the Terminal Value.<\/li>\n<li>And then <strong>project<\/strong> the Net Interest Expense based on these issuances and repayments, the company\u2019s Cash balance, and the prevailing interest rates, accounting for how they might change over time.<\/li>\n<\/ol>\n<p>When interest rates are extremely low, you could simplify Step #3 and assume no Interest Income from the Cash balance, but the Debt projections alone still add a lot of work.<\/p>\n<p>The beauty of an Unlevered DCF is that you can skip these projections and focus on the company\u2019s <strong>core business<\/strong> and the revenue, expenses, and cash flow items associated with it:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-25690 size-full\" title=\"Unlevered Free Cash Flow in a DCF\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074803\/Levered-Free-Cash-Flow-Image-02.jpg\" alt=\"Unlevered Free Cash Flow in a DCF\" width=\"1042\" height=\"513\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074803\/Levered-Free-Cash-Flow-Image-02.jpg 1042w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074803\/Levered-Free-Cash-Flow-Image-02-300x148.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074803\/Levered-Free-Cash-Flow-Image-02-1024x504.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074803\/Levered-Free-Cash-Flow-Image-02-768x378.jpg 768w\" sizes=\"(max-width: 1042px) 100vw, 1042px\" \/><\/p>\n<p>With a Levered DCF, though, you spend far more time on these schedules that have nothing to do with a company\u2019s core business.<\/p>\n<p>Item #5 is also bad because it means you might also need separate schedules for Net Operating Losses, Pensions, and more.<\/p>\n<p>You can get a sense of these changes in the simple analysis below:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-25691 size-full\" title=\"Levered Free Cash Flow Differences\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074802\/Levered-Free-Cash-Flow-Image-03.jpg\" alt=\"Levered Free Cash Flow Differences\" width=\"998\" height=\"678\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074802\/Levered-Free-Cash-Flow-Image-03.jpg 998w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074802\/Levered-Free-Cash-Flow-Image-03-300x204.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074802\/Levered-Free-Cash-Flow-Image-03-768x522.jpg 768w\" sizes=\"(max-width: 998px) 100vw, 998px\" \/><\/p>\n<p>Revenue and <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/ebit-operating-income\/\" target=\"_blank\" rel=\"noopener\">Operating Income<\/a> are the same, but many items below them differ since we build to Net Income rather than NOPAT.<\/p>\n<p>If this company had Preferred Stock, we\u2019d also subtract Preferred Stock Dividends here to calculate Net Income to Common.<\/p>\n<p>You might wonder why the <strong>Deferred Taxes<\/strong> change: how are they related to the company\u2019s capital structure?<\/p>\n<p>The answer is that the company\u2019s Book Income Taxes are lower in an analysis based on Levered Free Cash Flow due to the Net Interest Expense deduction, so we need to reduce the Deferred Income Taxes as well.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"US_GAAP_vs_IFRS_Issues_in_the_Levered_Free_Cash_Flow_Calculation\"><\/span><strong>U.S. GAAP vs. IFRS Issues in the Levered Free Cash Flow Calculation<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>With the issue of U.S. GAAP vs. IFRS, the main problem, as usual, lies in <a href=\"https:\/\/www.mergersandinquisitions.com\/lease-accounting\/\" target=\"_blank\" rel=\"noopener\" data-schema-attribute=\"\">lease accounting<\/a>.<\/p>\n<p>The same items go into Levered Free Cash Flow under both systems, but with IFRS, you have to be especially careful with Operating Leases.<\/p>\n<p>Specifically, since there is no \u201cbridge\u201d in a Levered DCF, you <strong>must<\/strong> deduct the full lease expense from both Operating Leases and Finance Leases in the FCF projections.<\/p>\n<p>This is easy under U.S. GAAP because the Operating Lease Expense is a simple \u201cRent\u201d line item on the Income Statement, and Finance Leases are often small or non-existent (and if they\u2019re not, keep reading).<\/p>\n<p>Under IFRS, however, expenses for both lease types are split into Interest and Depreciation (or Amortization) elements.<\/p>\n<p><strong>So, you must ensure that the Lease Interest and Lease Depreciation on the Income Statement are subtracted in Levered Free Cash Flow and do NOT get added back within the D&amp;A component of Levered FCF.<\/strong><\/p>\n<p>In practice, that means that you\u2019ll need to find a breakout of the company\u2019s Depreciation (or Amortization) and add back <em>only<\/em> the non-lease portions:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24251 size-full\" title=\"Levered Free Cash Flow Under IFRS\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075035\/IFRS-Levered-Free-Cash-Flow.png\" alt=\"Levered Free Cash Flow Under IFRS\" width=\"522\" height=\"171\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075035\/IFRS-Levered-Free-Cash-Flow.png 522w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075035\/IFRS-Levered-Free-Cash-Flow-300x98.png 300w\" sizes=\"(max-width: 522px) 100vw, 522px\" \/><\/p>\n<p>If you can\u2019t find this breakout, or the company does not disclose this information, then another option is to use the D&amp;A as listed on the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/cash-flow-statement\/\" target=\"_blank\" rel=\"noopener\">Cash Flow Statement<\/a> and then subtract the <strong>Lease Principal Repayments line<\/strong> within Cash Flow from Financing.<\/p>\n<p>In theory, this line item should be close to the Lease Depreciation for a large company with a diverse lease portfolio.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Will_a_DCF_Based_on_Levered_Free_Cash_Flow_Produce_Equivalent_Results\"><\/span><strong>Will a DCF Based on Levered Free Cash Flow Produce Equivalent Results?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>No!<\/p>\n<p>Continuing with the examples from above, the Unlevered and Levered DCF analyses do <strong>not<\/strong> produce the same results:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-25692 size-full\" title=\"Unlevered vs. Levered DCF Output and Implied Share Prices\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074802\/Levered-Free-Cash-Flow-Image-04.jpg\" alt=\"Unlevered vs. Levered DCF Output and Implied Share Prices\" width=\"816\" height=\"981\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074802\/Levered-Free-Cash-Flow-Image-04.jpg 816w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074802\/Levered-Free-Cash-Flow-Image-04-250x300.jpg 250w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074802\/Levered-Free-Cash-Flow-Image-04-768x923.jpg 768w\" sizes=\"(max-width: 816px) 100vw, 816px\" \/><\/p>\n<p>They are\u00a0<em>very close<\/em>, but they&#8217;re\u00a0<strong>not<\/strong> identical for a few key reasons:<\/p>\n<p><strong>1) Lack of Equivalent Changes<\/strong> \u2013 If the interest rate on Debt is 5% rather than 10%, that makes an immediate impact on each Levered Free Cash Flow in a Levered DCF. But it does <strong>not<\/strong> impact the Unlevered DCF directly; the market value of Debt in the Enterprise Value might change, but that single change won\u2019t be <em>equivalent<\/em> to the cumulative impact of a different FCF figure in each year of the 10-year forecast.<\/p>\n<p><strong>2) More \u201cVolatile\u201d FCF Numbers<\/strong> \u2013 Large Debt issuances and repayments may distort the numbers for multiple years, and it\u2019s almost impossible to make them &#8220;equivalent&#8221; to the single line item for Debt in the standard TEV bridge:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-25693 size-full\" title=\"Volatility of Levered FCF Projections in a DCF\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074801\/Levered-Free-Cash-Flow-Image-05.jpg\" alt=\"Volatility of Levered FCF Projections in a DCF\" width=\"1089\" height=\"167\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074801\/Levered-Free-Cash-Flow-Image-05.jpg 1089w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074801\/Levered-Free-Cash-Flow-Image-05-300x46.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074801\/Levered-Free-Cash-Flow-Image-05-1024x157.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074801\/Levered-Free-Cash-Flow-Image-05-768x118.jpg 768w\" sizes=\"(max-width: 1089px) 100vw, 1089px\" \/><\/p>\n<p><strong>3) Terminal Multiples and Growth Rates<\/strong> \u2013 Finally, it\u2019s very difficult to pick Terminal Multiples that are consistent with the multiples from the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/comparable-company-analysis-cca\/\" target=\"_blank\" rel=\"noopener\" data-schema-attribute=\"\">Comparable Company Analysis<\/a> <em>and<\/em> that imply reasonable Terminal Growth Rates <em>and<\/em> that produce output similar to the Unlevered DCF.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Is_Levered_Free_Cash_Flow_Useful_for_Anything_What_About_the_Levered_DCF\"><\/span><strong>Is Levered Free Cash Flow Useful for Anything? What About the Levered DCF?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>We strongly recommend against the Levered DCF unless someone has <em>specifically<\/em> asked you to build one.<\/p>\n<p>Here are some of the many problems with it:<\/p>\n<p><strong>1) It takes more time and effort<\/strong> because you have to project the company\u2019s Cash and Debt balances, Net Interest Expense, changes in Debt principal, and more.<\/p>\n<p>And even if you simplify these assumptions, more judgment and guesswork are required to ensure consistency:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-25694 size-full\" title=\"Levered FCF Projections - Consistency Issues with the Capital Structure\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074800\/Levered-Free-Cash-Flow-Image-06.jpg\" alt=\"Levered FCF Projections - Consistency Issues with the Capital Structure\" width=\"996\" height=\"570\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074800\/Levered-Free-Cash-Flow-Image-06.jpg 996w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074800\/Levered-Free-Cash-Flow-Image-06-300x172.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19074800\/Levered-Free-Cash-Flow-Image-06-768x440.jpg 768w\" sizes=\"(max-width: 996px) 100vw, 996px\" \/><\/p>\n<p><strong>2) The FCF numbers are more volatile<\/strong> than those produced by an Unlevered DCF because the Debt principal repayments could be $0 in some years and massive in others. The company\u2019s capital structure will heavily influence its implied share price.<\/p>\n<p><strong>3) You will NOT get the same results<\/strong> in a Levered DCF analysis because it is almost impossible to pick assumptions that are \u201cequivalent\u201d to those in an Unlevered DCF (see above).<\/p>\n<p><strong>4) There\u2019s disagreement about how to calculate Levered Free Cash Flow<\/strong>. Some people factor in <em>all<\/em> Debt issuances and repayments, some factor in <em>all<\/em> repayments but no issuances, and some factor in <em>only<\/em> the mandatory repayments.<\/p>\n<p>An Unlevered DCF is easier to set up and produces more consistent results that depend far less on a company\u2019s capital structure.<\/p>\n<p>There are a few specialized cases where a Levered DCF might be helpful (e.g., with <a href=\"https:\/\/breakingintowallstreet.com\/real-estate-modeling\/\" target=\"_blank\" rel=\"noopener\" data-schema-attribute=\"\">Equity REITs<\/a>), but 99% of the time, the Unlevered DCF is superior.<\/p>\n<p>The Levered DCF works in these specialized cases because some companies, such as Equity REITs, issue predictable amounts of Debt and Equity each year and have more &#8220;level&#8221; repayment schedules than normal companies (mostly because they use far more Debt).<\/p>\n<p>If you look up Levered DCFs from the large banks, you\u2019ll find that they are almost always created for <a href=\"https:\/\/www.sec.gov\/Archives\/edgar\/data\/1496048\/000119312518147835\/d579016dex99c6.htm\" target=\"_blank\" rel=\"noopener\">REITs<\/a> or <a href=\"https:\/\/www.sec.gov\/Archives\/edgar\/data\/1534126\/000104746921000773\/a2243110zex-99_c3.htm\" target=\"_blank\" rel=\"noopener\">midstream (pipeline) oil &amp; gas companies<\/a>, as in the examples below.<\/p>\n<p>This first one is from <a href=\"https:\/\/www.sec.gov\/Archives\/edgar\/data\/1496048\/000119312518147835\/d579016dex99c6.htm\" target=\"_blank\" rel=\"noopener\">Goldman Sachs&#8217; presentation to Brookfield and GGP<\/a>:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24248 size-full\" title=\"Levered DCF Analysis for a REIT\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075037\/07-Levered-DCF-REIT.png\" alt=\"Levered DCF Analysis for a REIT\" width=\"870\" height=\"386\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075037\/07-Levered-DCF-REIT.png 870w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075037\/07-Levered-DCF-REIT-300x133.png 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075037\/07-Levered-DCF-REIT-768x341.png 768w\" sizes=\"(max-width: 870px) 100vw, 870px\" \/><\/p>\n<p>And here&#8217;s a midstream (oil &amp; gas transportation) example from <a href=\"https:\/\/www.sec.gov\/Archives\/edgar\/data\/1534126\/000104746921000773\/a2243110zex-99_c3.htm\" target=\"_blank\" rel=\"noopener\">Evercore&#8217;s presentation to GasLog<\/a>:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24249 size-full\" title=\"Levered DCF Analysis for an Oil &amp; Gas MLP\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075036\/08-Levered-DCF-MLP.png\" alt=\"Levered DCF Analysis for an Oil &amp; Gas MLP\" width=\"687\" height=\"431\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075036\/08-Levered-DCF-MLP.png 687w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075036\/08-Levered-DCF-MLP-300x188.png 300w\" sizes=\"(max-width: 687px) 100vw, 687px\" \/><\/p>\n<p>Outside of the DCF analysis, Levered FCF is sometimes a good <strong>screening tool<\/strong> because it tends to represent a company\u2019s real-world cash flow more accurately than Unlevered FCF.<\/p>\n<p>For example, in a leveraged buyout, the private equity firm does not care about the company\u2019s \u201ctheoretical\u201d cash flow available to all investors.<\/p>\n<p>All it cares about is the company\u2019s cash flow available to distribute dividends or repay Debt, and Levered Free Cash Flow is much closer to that number.<\/p>\n<p>So, if you\u2019re looking for LBO candidates as part of a <a href=\"https:\/\/www.mergersandinquisitions.com\/private-equity-case-study\/\" target=\"_blank\" rel=\"noopener\">private equity case study<\/a>, it might be helpful to screen companies by Levered Free Cash Flow.<\/p>\n<p>That said, it\u2019s not much better than the standard &#8220;<a href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/how-to-calculate-free-cash-flow\/\" target=\"_blank\" rel=\"noopener\" data-schema-attribute=\"\">Free Cash Flow<\/a>&#8221; metric, which excludes Debt issuances and repayments, and standard FCF is easier to find and calculate.<\/p>\n<p>In fact, the normal FCF metric might be <em>better<\/em> for screening LBO candidates because companies&#8217; capital structures are wiped out and replaced in leveraged buyouts, so the post-transaction Debt repayment numbers will change anyway.<\/p>\n<p>Here\u2019s a comparison table:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-24250 size-full\" title=\"Free Cash Flow, Unlevered Free Cash Flow, and Levered Free Cash Flow - Comparison\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075036\/09-Unlevered-vs-Levered-Free-Cash-Flow.png\" alt=\"Free Cash Flow, Unlevered Free Cash Flow, and Levered Free Cash Flow - Comparison\" width=\"784\" height=\"1164\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075036\/09-Unlevered-vs-Levered-Free-Cash-Flow.png 784w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075036\/09-Unlevered-vs-Levered-Free-Cash-Flow-202x300.png 202w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075036\/09-Unlevered-vs-Levered-Free-Cash-Flow-690x1024.png 690w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2022\/01\/19075036\/09-Unlevered-vs-Levered-Free-Cash-Flow-768x1140.png 768w\" sizes=\"(max-width: 784px) 100vw, 784px\" \/><\/p>\n<p>Finally, note that Levered Free Cash Flow is also different from the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/cash-flow-available-for-debt-service-cfads\/\" target=\"_blank\">Cash Flow Available for Debt Service (CFADS)<\/a> metric used in Project Finance. The biggest difference is that LFCF fully deducts the <em>Debt Service<\/em> itself (the Interest Expense and Debt Principal Repayments), while CFADS does not.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Levered_Free_Cash_Flow_Much_Ado_About_Nothing\"><\/span><strong>Levered Free Cash Flow: Much Ado About Nothing?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>In our view, you should never spend more than a few minutes thinking about Levered Free Cash Flow and the Levered DCF.<\/p>\n<p>These methodologies are not useful in 99% of real-world situations, and you need to know about them mostly to answer possible interview questions about variations of the traditional DCF model.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>In this tutorial, you&#8217;ll learn what Levered Free Cash Flow means, how to calculate it, how to use it in a Discounted Cash Flow (DCF) analysis, and why we recommend against using it in most cases.<\/p>\n","protected":false},"featured_media":0,"template":"","class_list":["post-24241","biws_kb","type-biws_kb","status-publish","hentry","kb_category-valuation"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/24241","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=24241"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}