Many valuation models start with EBIT. EBIT includes all kinds of income earnings and expenses before only interest and tax expenses. However, not all kinds of earnings and expenses that show up in EBIT must be valued when evaluating a business. What line items found in EBIT must be removed when preparing cash flows for a DCF?
Remember that you are valuing a business. Remember also that the value of a business is based on the present value of all future cash flows. You are using the current EBIT as a base to arrive at future cash flows. Therefore, this EBIT must reflect only items that you will expect in the future. And so, you remove any line items you do not expect to see in the future. These line items that must be removed include both favorable and adverse events. Some examples are given below:
Nonrecurring line items: Items that are one-off in nature must be removed. Examples include cash flows resulting from lawsuits/dispute settlement (inflowsand outflows), penalties, and fines, acquisitions and restructuring expenses (see questions related to acquisitions and restructuring), etc.
Temporary items: Some items are likely to reverse in time. For example, tax assets and liabilities, exchange rate gains and losses, gains and losses of market value changes in non-operating assets, etc. However, if the nature of the business or strategy causes any of the above to be expected in the future, these can be included. For example, some firms grow with acquisitions as a strategy. The expenses related to acquisition and restructuring can be reasonably expected to continue and therefore must be included.
In summary, any line item that you do not expect to see in the future is to be removed in your DCF valuation. These line items that must be removed include both favorable and adverse events.