Once you have projected the "top line" revenue, the next step is to determine how much it costs to generate that money. This involves estimating operating expenses, which are the costs a company incurs through its normal business operations . The goal here is to arrive at Operating Income, often referred to as EBIT (Earnings Before Interest and Taxes).

Fixed vs. Variable Costs

To build an accurate model, you must understand the difference between fixed and variable costs .

Variable Costs: these change in direct proportion to revenue. For a clothing retailer, the cost of the fabric is a variable cost. If they sell more shirts, they spend more on fabric.
Fixed Costs: These stay the same regardless of how much the company sells (within reason). Rent for the corporate office or the CEO's salary are fixed costs.

As a company grows, its fixed costs are spread over a larger revenue base. This leads to "operating leverage," where profits grow faster than revenue . If you see a company's SG&A (Selling, General, and Administrative) expenses dropping as a percentage of revenue, it’s often a sign of improving efficiency .

Projecting Expenses as a Percentage of Revenue

The most common way to forecast expenses in a micro-learning model is to use a "percentage of revenue" approach . If a company’s SG&A has historically been 10% of its revenue, and there are no major changes expected, you can use that 10% figure for your future projections .

Expense = Projected Revenue × Expense %

Example: Margin Expansion at TechCo

If TechCo (from our previous example) has $112M in Year 1 revenue and we assume their operating expenses will be 80% of revenue:

Year 1 Revenue: $112M
Operating Expenses (80%): $89.6M
Operating Income (EBIT): $22.4M

The Role of EBITDA

Analysts frequently use EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) as a key metric . EBITDA is often seen as a proxy for the "cash-generating power" of the business operations because it adds back non-cash accounting charges like depreciation .

Metric	Definition	Why it matters in DCF
EBIT	Operating Profit	Shows the true operational success of the business .
EBITDA	EBIT + Depreciation + Amortization	A "cleaner" look at cash flow before big equipment costs .
Net Income	The "Bottom Line"	Includes interest and taxes; less useful for "unlevered" models .

Accounting for Taxes

Even though we are looking for "unlevered" cash flow (ignoring debt), we cannot ignore the government. Taxes are generally linked to pre-tax income rather than revenue . For a domestic U.S. company, you might use the standard corporate tax rate as an assumption .

In an unlevered model, we calculate "Taxes on EBIT." This represents what the company would pay in taxes if it had no debt and therefore no interest tax shields . This keeps the valuation focused on the business assets themselves .

Step-by-Step: From Revenue to NOPAT

Start with Revenue: Your Year 1 projection.
Subtract COGS: Cost of Goods Sold (variable costs).
Subtract SG&A: Operating expenses (fixed/semi-fixed).
Result = EBIT: Operating Income.
Subtract Cash Taxes: EBIT × Tax Rate.
Result = NOPAT: Net Operating Profit After Taxes.

NOPAT is a crucial milestone. It represents the total potential profit available to all investors if the company had no debt .

Frequently Asked Questions: Expenses

Q: What if a company is currently losing money?
A: Many high-growth companies have negative operating income early on. In your forecast, you must decide when the company will become "profitable." This usually happens as they gain scale and their fixed costs become a smaller portion of their total revenue .

Q: Why do we ignore interest expense?
A: In an "unlevered" free cash flow model, we want to value the business, not the financing. Interest depends on how much debt the company chose to take on. By ignoring it, we can compare a debt-heavy company to a debt-free company on equal footing .

Q: How do I know if an expense is "one-time"?
A: Look at the 10-K's "Selected Financial Data" or MD&A. Companies often highlight "restructuring charges" or "legal settlements" as one-time events. You should "strip these out" to find the recurring operating expenses for your forecast .