Unlevered Free Cash Flow (UFCF) Formula Explained | DCF Guide

Key takeaways

UFCF = EBIT × (1 - tax rate) + D&A ± changes in working capital - capex. This measures cash available to all investors (debt + equity), not just equity holders.
Exclude interest expense, non-recurring items, and financing cash flows. The point is to isolate recurring operating cash generation independent of capital structure.
Stock-based compensation should NOT be added back. It is a real economic cost that dilutes shareholders, even though it is non-cash.
UFCF is discounted at WACC (reflects all capital providers). Levered FCF is discounted at cost of equity (reflects equity only). Both should produce the same enterprise value if done correctly.

Why "Unlevered" Matters

A DCF values a company by discounting its future cash flows to the present. But cash flows to whom? Two approaches exist:

Metric	Cash Flow To	Discount Rate	Produces
Unlevered FCF (FCFF)	All investors (debt + equity)	WACC	Enterprise Value
Levered FCF (FCFE)	Equity investors only	Cost of Equity	Equity Value

Unlevered FCF is the standard in investment banking and PE because it is capital-structure neutral. Two identical businesses with different debt levels produce the same UFCF. This makes it possible to compare companies and value them independently of how they are financed.

"Unlevered" means interest expense is excluded. The cash flow represents what the business generates from operations before any payments to debt holders. The cost of debt is captured in the WACC discount rate instead.

The Formula

UFCF = EBIT × (1 - Tax Rate) + D&A ± Changes in Working Capital - Capex ± Deferred Tax Changes

Step by step:

Start with EBIT (operating income). Not EBITDA, not net income. EBIT is the right starting point because it is after operating expenses but before interest and taxes.

Tax-effect it: EBIT × (1 - tax rate) = NOPAT. This gives net operating profit after tax. Use the marginal tax rate, not the effective rate, because NOPAT should reflect the tax the company would pay if it had no debt (no interest tax shield). In practice, many analysts use the effective rate for simplicity.

Add back D&A. Depreciation and amortisation reduce EBIT but are non-cash charges. The cash was spent when the asset was originally purchased (captured in capex). Adding D&A back avoids double-counting the cash outflow.

Adjust for working capital changes. An increase in accounts receivable means revenue was recognised but cash was not collected (cash outflow). An increase in accounts payable means expenses were incurred but not yet paid (cash inflow). These adjustments convert accrual-basis profit to actual cash.

Subtract capex. Capital expenditures are the cash spent to maintain and grow the asset base. This is a real cash outflow that EBIT does not capture.

Adjust for deferred taxes (optional). If the company has significant deferred tax assets or liabilities, the difference between cash taxes paid and book tax expense should be reflected. In practice, this adjustment is small for most companies and often omitted in interview settings.

What to Include and What to Exclude

Item	Include?	Why
EBIT / operating income	Yes	Core operating earnings
D&A	Yes (add back)	Non-cash; real cash outflow is captured in capex
Capex	Yes (subtract)	Cash investment in productive assets
Working capital changes	Yes	Converts accrual profit to cash profit
Interest expense	No	Debt-specific; captured in WACC instead
Dividends	No	Equity-specific distribution, not an operating cash flow
Debt issuance / repayment	No	Financing activity, not operating
Non-recurring charges (restructuring, impairments)	No	One-time items that distort the recurring cash flow profile
Gains/losses on asset sales	No	Non-core, non-recurring
Acquisitions	Depends	Exclude for a standalone DCF. Include if the company is a serial acquirer and M&A is part of the operating model (but assume normalisation, not perpetual growth).

The Stock-Based Compensation Debate

This is the most contentious item in UFCF calculations and a common interview question. SBC is a non-cash charge on the income statement. The question is whether to add it back to UFCF, the way D&A is added back.

The answer: do not add SBC back Stock-based compensation is a real economic cost. When a company issues options or RSUs to employees, it dilutes existing shareholders. The cost is paid in equity value, not cash, but it is still a cost. Adding SBC back to UFCF overstates the cash flow available to investors because it ignores the dilution those investors will experience.

The logic: D&A is added back because the cash was already spent (when the asset was purchased). There is no future dilution from depreciation. SBC is different: the dilution is ongoing and directly reduces the value per share that each investor holds. Treating it as "free cash" is misleading.

In practice, some banks and analysts do add SBC back, particularly for high-growth tech companies where SBC is a large percentage of operating expenses. If you do, you must account for the dilution separately (using the treasury stock method to increase the share count). Either approach can work if applied consistently, but the cleaner method is to leave SBC as an expense.

Worked Example

Item	Amount (£M)
Revenue	500
EBIT	75
Tax rate	25%
NOPAT (EBIT × 0.75)	56.3
+ D&A	20.0
- Increase in working capital	(8.0)
- Capex	(25.0)
Unlevered Free Cash Flow	43.3

This £43.3M is the cash the business generates for all investors before any debt service or equity distributions. It is the number that gets projected forward and discounted at WACC in a DCF to produce enterprise value.

UFCF vs Levered FCF: When to Use Each

Use UFCF (discounted at WACC) when: valuing a company in most M&A and banking contexts. The result is enterprise value, from which you subtract net debt to get equity value. This is the standard approach.

Use levered FCF (discounted at cost of equity) when: valuing financial institutions (where debt is an operating liability, not a financing choice) or when the capital structure is fixed and will not change. The result is equity value directly. This is the standard approach in FIG banking and FIG valuation.

Interview Questions

"How do you calculate unlevered free cash flow?"

Start with EBIT, tax-effect it at the marginal rate to get NOPAT, add back D&A, adjust for working capital changes, and subtract capex. This gives cash flow to all investors, independent of capital structure. It is discounted at WACC in a DCF to produce enterprise value.

"Why do you use UFCF instead of levered FCF in a DCF?"

UFCF is capital-structure neutral. It allows comparison of companies with different debt levels on a like-for-like basis. The cost of debt is captured in the WACC discount rate rather than in the cash flow itself. This separation makes the valuation cleaner and more flexible.

"Should you add back stock-based compensation?"

Preferably not. SBC is a real economic cost that dilutes equity holders. Unlike D&A, where the cash was already spent, SBC represents an ongoing transfer of value from existing shareholders to employees. If you do add it back, you must increase the share count using the treasury stock method to account for the dilution. Either approach works if applied consistently.

"Why do you start with EBIT and not net income?"

Net income is after interest expense, which is a debt-specific cost. Since UFCF measures cash flow to all investors (including debt holders), interest should not be deducted. Starting with EBIT and applying the tax rate directly gives NOPAT, which is the pre-interest, post-tax operating profit.

Take Your Preparation Further

Download our free Valuation Cheat Sheet for the complete DCF methodology, WACC build-up, and terminal value formulas. For a hands-on DCF model, see the DCF Model Template.

For how terminal value is calculated from UFCF, see DCF Terminal Value Explained.

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Unlevered Free Cash Flow: The Formula, What to Include, and the SBC Debate