Glossary 21 – DFCF – Debt-free Cash-free valuation in M&A transactions
We already heard about DCF valuation method. How about DFCF?
In mergers and acquisitions (M&A), the Debt-Free Cash-Free (DFCF) approach is a widely used method to determine the valuation of a target company. This approach focuses on the value of the company’s core operations, excluding its financial structure, by removing the effects of debt and cash from the Enterprise Value (EV).
In a DFCF transaction, the buyer agrees to purchase the company without assuming its existing debt or acquiring its cash reserves. The seller retains any excess cash and is responsible for settling all outstanding debts. Given the DFCF approach, the value of the company’s operating assets is independent of how those assets are financed. As a result, the purchase price which a buyer would pay to acquire the company is based on the value of its operational assets and liabilities only. To obtain the purchase price, the target’s net debt (total debt minus cash and cash equivalents) is subtracted from its EV.
Besides its simplicity and clarity, DFCF approach is particularly useful because it allows for a clearer comparison between companies, regardless of their capital structures. By taking out the effects of debt and cash, the DFCF approach provides a more accurate reflection of the company’s operational performance and potential. This method also reduces the risk of post-closing adjustments and disputes, as the financial position of the company is clearly defined at the time of the transaction. For the buyer, this means that the valuation is based on the future cash flows generated by the business, rather than on the existing liabilities or excess cash reserves.
However, the DFCF approach also has its challenges. It requires accurate and up-to-date financial information to correctly calculate net debt, and there can be complexities in defining which items should be considered as cash or debt. Additionally, this method may not fully capture the financial health of a company as it does not account for the potential strategic value of cash reserves and any preferential debt on the overall valuation.
