Typically, the Discounted Cash Flow (DCF) method tends to give the highest valuation. This method calculates the present value of expected future cash flows using a discount rate, often resulting in a higher valuation because it considers the company's potential for future growth and profitability.
A Leveraged Buyout (LBO) can lead to a lower valuation for several reasons: Debt Financing: LBOs typically involve a significant amount of debt to finance the acquisition. The high leverage increases financial risk, which can lead to a lower valuation as investors require a higher return to compensate for that risk.
Most finance courses espouse the gospel of discounted cash flow (DCF) analysis as the preferred valuation methodology for all cash flow-generating assets. In theory (and in college final examinations), this technique works great. In practice, however, DCF can be difficult to apply in evaluating equities.
According to The Appraisal Institute the highest and best use of a property is defined as: "The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, and financially feasible and that results in the highest value."
The main drawback of DCF analysis is that it's easily prone to errors, bad assumptions, and overconfidence in knowing what a company is actually “worth”.
There are a couple situations where you would use an LBO analysis in your valuation. The first situation is obviously whenever you're looking at doing a leveraged buyout of a business and want to figure out how much you could pay for a business and still hit a desired IRR (usually 15-20%).
TXU (A): Powering the Largest Leveraged Buyout in History
The 2007 purchase of TXU, the largest utility in Texas, was the largest leveraged buyout in history. Yet, within seven years TXU was bankrupt.
Leverage Buyout (LBO) Analysis
Pro: LBO valuation is realistic, as it does not require synergies to achieve (financial buyers usually do not have synergy opportunities). Con: Ignoring synergies could result in an underestimated valuation, particularly for a well-fitting strategic buyer.
Discounted Cash Flows
This technique is highlighted in Leading with Finance as the gold standard of valuation. Discounted cash flow analysis is the process of estimating the value of a company or investment based on the money, or cash flows, it's expected to generate in the future.
We do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech start-up) or when debt and working capital serve a fundamentally different role.
LBO models will theoretically provide the lowest valuation, since they represent a floor value for the company.
Levered DCF: The levered DCF approach calculates the equity value directly, unlike the unlevered DCF, which arrives at the enterprise value (and requires adjustments thereafter to arrive at equity value). Unlevered DCF: The unlevered DCF discounts the unlevered FCFs to arrive at the enterprise value (TEV).
This method is intrinsic and based on the company's own expected performance rather than comparative metrics. In LBO settings, the Internal Rate of Return (IRR) is a crucial metric. It represents the annualised effective compounded return rate that can be expected on the equity invested in the deal.
Returns are generated in an LBO in three ways: The company pays down its debt and this deleveraging increases the amount of equity in the company. Investors are able to improve profit margins by reducing or eliminating unnecessary expenditures and improving sales.
LBO – An LBO usually yields a lower valuation. It is a leveraged buyout driven by IRR rather than strategic value. After all, the private equity fund wants to sell the company for a profit down the road. Here the numbers of the entire acquisition must add up.
In a competitive marketplace, a company may use leverage to acquire one of its competitors (or any company where it could achieve synergies from the acquisition). The plan is risky: The company needs to make sure the return on its invested capital exceeds its cost to acquire, or the plan can backfire.
LBOs are popular partly because if the company goes south, the debt can be written off as a tax loss. But critics argue that LBOs often benefit private equity firms at the expense of the company's employees, noting that about 20 percent of companies acquired through LBOs file for bankruptcy within ten years.
LBO and DCF are financial modeling methods for investment decisions, but they have different goals. LBO focuses on acquiring and managing a company to produce returns through operational improvements and sales. However, DCF estimates investment intrinsic value based on future cash flows.
Private Equity and Venture Capital firms use investor money (or 'Equity') to invest in businesses that are not publicly traded. The primary difference between these funds is that Venture Capital funds invest in young, early-stage businesses and Private Equity (i.e. LBO) funds invest in mature, late-stage businesses.
The rule of thumb for IRR (Internal Rate of Return) is that it should generally exceed the cost of capital to ensure profitability. For private equity and LBO (Leveraged Buyout) investments, a typical target IRR is around 20-30%, reflecting the higher risk and expected returns of such investments.
DCF Valuation truly captures the underlying fundamental drivers of a business (cost of equity, weighted average cost of capital, growth rate, re-investment rate, etc.). Consequently, this comes closest to estimating intrinsic value of the asset/business. Unlike other valuations, DCF relies on Free Cash Flows.
Discounted cash flow (DCF) is a valuation method that estimates the value of an investment using its expected future cash flows. Analysts use DCF to determine the value of an investment today, based on projections of how much money that investment will generate in the future.