Levered Free Cash Flow (LFCF) is a fundamental financial metric used by investors and analysts to assess the amount of cash generated by a company after accounting for interest payments on its outstanding debt. In simpler terms, it's the cash flow available to equity holders (shareholders) after meeting all obligations. LFCF is an essential tool for assessing a company's capacity to generate shareholder returns, finance dividends, and determine its valuation.
How is Levered Free Cash Flow Calculated?
The basic formula for LFCF is:
LFCF = Unlevered Free Cash Flow (UFCF) − Interest Expense + Tax Shield on Interest Expense
UFCF: Cash flow available before accounting for interest payments. It's essentially the operating income minus taxes, changes in net working capital, and capital expenditures.
Interest Expense: Cost of debt or the interest payments on a company's outstanding loans.
Tax Shield on Interest Expense: Since interest payments are tax-deductible, companies get a tax benefit. This tax shield is calculated as Interest Expense multiplied by the corporate tax rate.
Why is LFCF Important for Investors?
Valuation: LFCF is an essential metric for Discounted Cash Flow (DCF) valuation, where future LFCFs are discounted back to the present value to derive a company's intrinsic value.
Solvency: Regular positive LFCF indicates that a company can comfortably service its debt and distribute dividends.
Growth: Companies with strong LFCF might reinvest this cash to finance growth initiatives or acquisitions.
Comparative Analysis: By comparing LFCF across companies within the same industry, investors can ascertain which companies are generating superior returns on their debt.
Examples of Levered Free Cash Flow Analysis
Example 1: Company A - A Mature Company
UFCF: $5 million
Interest Expense: $1 million
Tax Shield on Interest Expense (assuming a 30% corporate tax rate): $1 million * 30% = $0.3 million
LFCF: $5 million - $1 million + $0.3 million = $4.3 million
For a mature company like Company A, having a strong LFCF of $4.3 million suggests that it's generating ample cash for shareholders after servicing its debt. Investors may expect dividends or share buybacks from such a company.
Example 2: Company B - A Growth Company
UFCF: $2 million
Interest Expense: $1.5 million
Tax Shield on Interest Expense (assuming a 30% corporate tax rate): $1.5 million * 30% = $0.45 million
LFCF: $2 million - $1.5 million + $0.45 million = $0.95 million
For a growing company like Company B, the LFCF is comparatively lower, signifying that it's taking on more debt to fuel its expansion. While this isn't necessarily bad, investors should be mindful of the company's ability to service this debt and ensure it translates to growth in revenues and profits.
Caveats & Limitations
While LFCF is a valuable tool, it's crucial for investors to consider the following:
Volatility: LFCF can be volatile from year to year based on capital expenditure decisions and changes in working capital.
Not the Only Metric: Relying solely on LFCF can be misleading. It should be used in conjunction with other financial metrics like EBITDA, Net Income, and Debt to Equity ratio.
Industry Specifics: Some industries (like tech startups) might have negative LFCF in their early years due to significant reinvestment needs.
Levered Free Cash Flow provides investors a clearer picture of the cash a company generates after meeting its debt obligations. When used judiciously alongside other financial metrics, it can be an essential tool in an investor's arsenal for stock valuation and comparison.