The past few weeks, I’ve been teaching a course called Strategic Financial Analysis. In the course, we are using Netflix as a case study to understand financial concepts. Through my research, I ran into a problem. 

The problem was that Netflix derived it’s free cash flow from cash from operating activities, which is derived from net income. This is a problem because net income is after interest expense, so the free cash flow metric provided is only available for equity holders!

I always learned free cash flow to be the north star metric. Profits don’t matter as much as cash flow. This is because net income doesn’t take into account capital expenditures or changes in working capital. And so to get a more accurate understanding of the business, cash flow is used instead. 

But there are multiple kinds of cash flow. Two kinds of free cash flow are levered and unlevered. Levered free cash flow is only available to equity holders: because it’s calculated after Interest Expense, it’s already satisfied obligations to the debt side. While lenders have a right to the (legally contracted) Interest Expense, they have no right to anything beyond that. (Think about it: can you imagine if your mortgage just decided to charge you more because you were able to increase rent?) 

Unlevered free cash flow is called unlevered because, well, the cash flow is available to both debt and equity. Unlevered free cash flow is the cash flow before you pay the interest expense that you owe your lenders. You might think: if you are evaluating buying shares of the company (equity), why would you care about cash flow before you take out a real obligation like interest expense? 

The reason is that you can evaluate the business independent of capital structure. The amount of debt and equity that a business holds -- how it’s capitalized -- doesn’t impact the operations of the business itself. For example, having less debt doesn’t help you get more customers. And so if you want to analyze the prospects of a business, it makes good sense to do so without the impact of interest expense. 

This post is an explanation of how I now understand free cash flow to equity and what it means for valuation. Let’s get into it. 

Profitability and Cash Flow

"No matter whether a company makes telecom equipment, cars, or candy, it's still the same question: How much cash do we get and when?" - Warren Buffett

Before diving into filings, let’s go over the basics of profitability. 

First is getting revenue down to gross profit: just take out cost of goods sold. Cost of goods sold is any expense directly related to servicing revenue delivery. 

After COGS comes operating expenses. These include other operating costs to the business like marketing, R&D and G&A. Subtract those from gross profit to get down to operating income. 

After operating expenses, we subtract out interest expense and taxes to get to net income. 

As mentioned before, interest expense and taxes both aren’t really related to the operations of the business. Issuing more debt or Uncle Sam changing the tax code aren’t in the scope of operations. 

Next we make all of our adjustments from Net Income to Free Cash Flow. 

Let’s quick walk through why we need these adjustments to get from Net Income to Free Cash Flow:

• D&A: D&A is the expense associated with a capitalized asset. Example: you buy a machine for your manufacturing plant for $50m and it has a useful life of 5 years. Depreciation allows you to expense $10m every year ($50m / 5 years) instead of taking a lump sum. Normally it’s taken out in operating expenses, but since you aren’t actually handing over cash to someone, we add it back to get to cash flow. 
• SBC: Stock-based compensation includes things like options and equity grants. The reason we add them back here is because options and equity grants aren’t cash. It’ll become cash one day, but we don’t worry about that. 😅 (There’s an entire post to be written about this, but I’m not going to get into it here.)
• Change in Working Capital: this is another one where the changes in Current Assets (like the money people owe you or your inventory on hand) and Current Liabilities (like the money you owe people) should be accounted for in cash. More on working capital in this cash conversion cycle post. 
• Capital Expenditures: we take out Capital Expenditures because we are aiming at getting to a true cash number. Anytime you make an investment, you pay cash. 
  

Levered vs Unlevered Free Cash Flow 

Alright now what’s the difference between Levered and Unlevered Free Cash Flow?

(Note: the percent tax rate would be calculated the same, but the dollar value would be different due to not taking Interest Expense into account.)

The key difference here is interest expense. Unlevered FCF isn’t affected by interest expense, while levered FCF is. 

You could even go beyond Interest Expense. The CFA definition of levered free cash flow also takes out debt principal payment. From talking to public equity analysts, no one does this, even though it’s critical in private markets (particularly LBOs that use debt paydown as a significant driver of equity returns). 

When evaluating the operations of a business, I would think to use unlevered FCF because it fully takes out. However, when I looked at public companies, they were leaving in interest expense. Here’s a quick example of what I’m talking about. 

Netflix’s Free Cash Flow

First, Netflix takes out interest expense (red) out of net income (orange), as they should. 

Then, the reconciliation from net income to cash from operating activities. Net income (orange) gets adjusted for non-cash expenses like changes in content amortization and stock-based compensation, as it should, down to cash from operating activities (blue). 

Note that there isn’t a line item adjusting back interest expense. 

And finally, the reconciliation from cash from operating activities (blue) to free cash flow (green). Netflix takes out all capital expenditures. 

Notice how there’s no add back or adjustment for interest expense, so this free cash flow number is actually levered free cash flow. 

Implications for Multiples and Modeling

Alright so why does this all matter?

It comes down to multiples and understanding how cash flows are valued. Since publicly listed FCF numbers are levered, you should use share price or equity value as the numerator for your multiples. Think of this as closer to a “cash earnings” rather than a true cash flow. 

The reason I rarely ran into this in the M&A world is that when you buy a controlling interest of a business, you are legally required to pay down the existing debt. With public markets, it’s much more common to buy a slice of the existing equity without buying a controlling interest. So, you look at levered returns to equity. 

At the end of the day, a prudent financial analyst is going to model out all of these assumptions and compare across their peers. If two companies in a similar industry, with a similar growth rate have large variance between EV/FCFF and Equity Value/FCFE, that’s something to note. Why is one management team carrying more debt than the other? Do you expect them to continue to carry a higher multiple of debt (employing a levered buyback strategy) or do they plan on paying down the debt? What are incremental projects they can deploy capital into?