One forecast year built from EBIT and from EBITDA, then the five usual errors, each priced in enterprise value.
Unlevered free cash flow is the cash the operations generate for all capital providers: EBIT taxed as if the company had no debt, plus depreciation and amortisation, less capital expenditure and the increase in net working capital. On 50,000,000 of revenue at an 18 per cent EBITDA margin, unlevered free cash flow is 4,645,000, or 51.6 per cent of EBITDA. The interest is left out on purpose: the WACC already charges for the debt.
Worked in full in Business Valuation by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The formula is in every textbook. The errors are in which tax, which capital expenditure and which working capital, and each one is recurring: it lands in every forecast year and then in the terminal value. Below, one year built two ways, then each error priced.
| Input | Value |
|---|---|
| Revenue, prior year | 46,000,000 |
| Revenue, year one (growth 8.7%) | 50,000,000 |
| EBITDA margin | 18% |
| Depreciation and amortisation | 1,500,000 |
| Capital expenditure (4% of revenue) | 2,000,000 |
| Net working capital, % of revenue | 12% |
| Tax rate | 25% |
| Interest expense (excluded from UFCF) | 1,200,000 |
| Line | Amount |
|---|---|
| Revenue | 50,000,000 |
| EBITDA (18%) | 9,000,000 |
| less depreciation and amortisation | −1,500,000 |
| EBIT | 7,500,000 |
| less tax on EBIT at 25% | −1,875,000 |
| NOPAT | 5,625,000 |
| add back depreciation and amortisation | 1,500,000 |
| less capital expenditure | −2,000,000 |
| less increase in net working capital | −480,000 |
| Unlevered free cash flow | 4,645,000 |
UFCF = EBIT × (1 − t) + D&A − capex − ΔNWC
= 7,500,000 × 0.75 + 1,500,000 − 2,000,000 − 480,000 = 4,645,000
Excel: =EBIT*(1-Tax)+DA-Capex-(NWCpct*Rev-NWCpct*RevPrior)
The working capital line. Working capital at 12 per cent of revenue is 5,520,000 last year and 6,000,000 this year. Only the increase, 480,000, is a cash outflow: it is the receivables and inventory the extra 4,000,000 of revenue ties up.
Route 2: from EBITDA. The same answer, quicker, and the form most models use: EBITDA less the tax on EBIT, less capital expenditure, less the increase in working capital. 9,000,000 minus 1,875,000 minus 2,000,000 minus 480,000 is 4,645,000. The tax is still computed on EBIT, because depreciation is deductible even though it is not cash.
4,645,000 is 51.6 per cent of EBITDA. That conversion ratio is the first reasonableness check a reviewer should run: a company that reinvests 4 per cent of revenue and grows 8.7 per cent a year cannot convert 80 per cent of EBITDA into cash. Capitalised at a 9.0 per cent WACC and 2.0 per cent growth (a factor of 14.2857), each 1 of recurring UFCF is worth 14.29 of enterprise value, which is the scale on which the errors below should be read.
| Capex, % of revenue | NWC 8% | NWC 12% | NWC 16% |
|---|---|---|---|
| 3% | 5,305,000 | 5,145,000 | 4,985,000 |
| 4% | 4,805,000 | 4,645,000 | 4,485,000 |
| 5% | 4,305,000 | 4,145,000 | 3,985,000 |
A point of capital expenditure is worth 500,000 a year here, three times the 160,000 that four points of working capital intensity move. That ranking flips in a business that grows fast with little fixed investment, which is why both ratios should be inputs, not plugs.
| Error | UFCF shown | Error a year | Enterprise value error |
|---|---|---|---|
| Interest deducted from the cash flow, then discounted at WACC | 3,445,000 | −1,200,000 | −17,142,857 |
| Working capital ignored in a growing business | 5,125,000 | 480,000 | 6,857,143 |
| Capex set equal to D&A | 5,145,000 | 500,000 | 7,142,857 |
| Tax taken from the income statement, after interest | 4,945,000 | 300,000 | 4,285,714 |
| Stock-based compensation added back as non-cash | 5,045,000 | 400,000 | 5,714,286 |
The terminal year is where these errors are multiplied: see what percentage of a DCF the terminal value should be. The rate that discounts the cash flow is built in how to calculate WACC step by step.
Tax EBIT as if there were no debt, add back D&A, subtract capital expenditure and the increase in working capital: 4,645,000 here, 51.6 per cent of EBITDA. Check the conversion before anything else, and keep interest out of the cash flow. The free workbook for this book builds a five-year free cash flow line by line with every ratio as an input, and the DCF terminal value template takes it from there.
Unlevered free cash flow is before interest and debt flows, with tax computed on EBIT, and is discounted at the WACC to give enterprise value. Levered free cash flow is after interest and debt repayments and is discounted at the cost of equity to give equity value. In the case, deducting 1,200,000 of interest and still discounting at WACC would understate enterprise value by 17,142,857.
Because the tax saving from interest is already in the WACC, through the after-tax cost of debt. Using the tax actually paid, 1,575,000 instead of 1,875,000, adds the 300,000 shield to the cash flow a second time and overstates value by 4,285,714 at a 14.2857 capitalisation factor.
It depends on reinvestment, not on taste. A business spending 4 per cent of revenue on capex and growing 8.7 per cent a year converts 51.6 per cent of EBITDA here. Asset-light businesses with flat revenue can convert 70 per cent or more; capital-heavy growers far less. Check conversion against capex intensity and growth before trusting it.
The free cash flow is built line by line in chapters 4 to 8 of Business Valuation. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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