1/19/11

I've heard of the "four valuation methods" but I haven't been able to find out what those are. Anyone have a link?

Comments (36)

1/19/11

DCF, trading comps, Acquisition comps, and LBO

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1/19/11

What's the difference between trading comps and acquisition comps? I think that's where I'm stuck.

1/19/11

Trading comps: market data on where peers trade, the metrics change as market prices change
Precedent comps (aka, acquisition comps, transaction comps): shows at what valuation other peers were acquired in the past, the metrics do not change as the data is all historical

1/19/11

To conclude. The first shows the market's valuation of the peer group. The second shows the actual buyers' valuation.

1/19/11

C'mon man... thats one of the most basic interview questions... check out the guides. You have more points than I do and don't know the 4 valuation methods?

1/19/11

I don't know as much about equity research as I would like. That's why I asked.

1/19/11

What about DCF wacc, DCF APV, RIM and DDM?

Valor is of no service, chance rules all, and the bravest often fall by the hands of cowards. - Tacitus

Dr. Nick Riviera: Hey, don't worry. You don't have to make up stories here. Save that for court!

1/19/11
El_Mono:

What about DCF wacc, DCF APV, RIM and DDM?

Somebody correct me if I am wrong, but I think DDM is just something they like to teach in school and not really used much in the real world (not IBD at least).

Isn't APV useful for an LBO?

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger

1/20/11
nonpog:
El_Mono:

What about DCF wacc, DCF APV, RIM and DDM?

Somebody correct me if I am wrong, but I think DDM is just something they like to teach in school and not really used much in the real world (not IBD at least).

Isn't APV useful for an LBO?

Wrong. DDM is one of the primary valuation methods used in FIG groups.

1/19/11

I'd say those all fall under the "DCF" umbrella.

What's ironic is there is a Google Banner next to this thread, at least for me, advertising a WallStreetPrep program that teaches you to "build lbo, dcf, m&a, and comps models"

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1/19/11

There are multiple Methods but 3 main approaches to Business Valuations
1. Income Approach - DCF Method + All discounted Cash and Earnings models, including debt assumptions
2. Market Approach - Transactions Multiples Method + Guideline Comparables Method
3. Asset Approach - Replacement Methods + All related liquidation Models

The M&M theory says regardless of Debt added to the business the EV is still the same. In Leverage model, use the Ke for Equity CF, while in a Debt Free model use WACC, the PV should always be the same. LBO's, leverage leases, etc don't increase the EV, (Maybe the ROE).

This is only a theory and I have never gotten the same answer using Ke & WACC, regardless of the type of debt, Project Finance, LBO, Leverage Lease, Bank loan, etc. This is due to a static WACC in my Debt free model.

1/20/11

The "LBO method" isn't intended to give you the "intrinsic" value of the firm. All the LBO method does is tell you what valuation an LBO buyer could pay for the company to achieve a target equity return (usually around 20%+) assuming a leveraged capital structure. This valuation should be lower than a DCF because your discount rate (includes 20%+ "cost of equity") is higher. To calculate the LBO method value, all you do is build an LBO model with an equity IRR output and then goal seek the purchase price to target a 20% IRR.

Also, capital structure will affect TEV to some degree (that's why there's an "optimal capital structure" that minimizes the firm's WACC...minimizing WACC increases TEV). Modigliani Miller (M&M) makes some assumptions (e.g., companies don't pay tax) that aren't realistic.

Race:

There are multiple Methods but 3 main approaches to Business Valuations
1. Income Approach - DCF Method + All discounted Cash and Earnings models, including debt assumptions
2. Market Approach - Transactions Multiples Method + Guideline Comparables Method
3. Asset Approach - Replacement Methods + All related liquidation Models

The M&M theory says regardless of Debt added to the business the EV is still the same. In Leverage model, use the Ke for Equity CF, while in a Debt Free model use WACC, the PV should always be the same. LBO's, leverage leases, etc don't increase the EV, (Maybe the ROE).

This is only a theory and I have never gotten the same answer using Ke & WACC, regardless of the type of debt, Project Finance, LBO, Leverage Lease, Bank loan, etc. This is due to a static WACC in my Debt free model.

1/20/11
bankbank:

The "LBO method" isn't intended to give you the "intrinsic" value of the firm. All the LBO method does is tell you what valuation an LBO buyer could pay for the company to achieve a target equity return (usually around 20%+) assuming a leveraged capital structure. This valuation should be lower than a DCF because your discount rate (includes 20%+ "cost of equity") is higher. To calculate the LBO method value, all you do is build an LBO model with an equity IRR output and then goal seek the purchase price to target a 20% IRR.

Also, capital structure will affect TEV to some degree (that's why there's an "optimal capital structure" that minimizes the firm's WACC...minimizing WACC increases TEV). Modigliani Miller (M&M) makes some assumptions (e.g., companies don't pay tax) that aren't realistic.

Race:

There are multiple Methods but 3 main approaches to Business Valuations
1. Income Approach - DCF Method + All discounted Cash and Earnings models, including debt assumptions
2. Market Approach - Transactions Multiples Method + Guideline Comparables Method
3. Asset Approach - Replacement Methods + All related liquidation Models

The M&M theory says regardless of Debt added to the business the EV is still the same. In Leverage model, use the Ke for Equity CF, while in a Debt Free model use WACC, the PV should always be the same. LBO's, leverage leases, etc don't increase the EV, (Maybe the ROE).

This is only a theory and I have never gotten the same answer using Ke & WACC, regardless of the type of debt, Project Finance, LBO, Leverage Lease, Bank loan, etc. This is due to a static WACC in my Debt free model.

Wouldn't an LBO valuation give you a higher valuation than a DCF? Here is my reasoning, you assume a purchase premium in the purchase price of an lbo, you assume that you can increase the CF's of the company when a PE firm acquires it by making management changes / rolling over other companies / imrpoving ops etc, so the CF's alone will grow at a higher rate than when oing a DCF. I am only a recent grad about to start as an analyst next month, but this is my understanding and was an answer I gave an interviewer and he moved on.

Just would like some clarification.

1/20/11

[quote=
Wouldn't an LBO valuation give you a higher valuation than a DCF? Here is my reasoning, you assume a purchase premium in the purchase price of an lbo, you assume that you can increase the CF's of the company when a PE firm acquires it by making management changes / rolling over other companies / imrpoving ops etc, so the CF's alone will grow at a higher rate than when oing a DCF. I am only a recent grad about to start as an analyst next month, but this is my understanding and was an answer I gave an interviewer and he moved on.

Just would like some clarification.[/quote]

Thanks for clearing that up bank. Would you be able to comment on if an LBO can ever have a higher valuation than a DCF based on the above thought process? Thanks again.

Best Response
1/21/11
SHORTmyCDO:

[quote=
Wouldn't an LBO valuation give you a higher valuation than a DCF? Here is my reasoning, you assume a purchase premium in the purchase price of an lbo, you assume that you can increase the CF's of the company when a PE firm acquires it by making management changes / rolling over other companies / imrpoving ops etc, so the CF's alone will grow at a higher rate than when oing a DCF. I am only a recent grad about to start as an analyst next month, but this is my understanding and was an answer I gave an interviewer and he moved on.

Just would like some clarification.

Thanks for clearing that up bank. Would you be able to comment on if an LBO can ever have a higher valuation than a DCF based on the above thought process? Thanks again.[/quote]

I'm going to try and explain this simply, but it would be better explained with some math and modeling... Apologies in advance for being long-winded.

Also, a "financial sponsor" is a financial buyer (a private equity or VC firm, as opposed to a strategic/corporate buyer). So when I mention "financial sponsor" or "sponsor," I am referring to the PE firm doing the LBO.

An LBO valuation is akin to a DCF valuation, except the costs of capital are higher. When bankers talk about the LBO as a valuation method, they are thinking of the "valuation" in terms of the financial sponsor's ability to buy the company and generate a 20%+ IRR (most sponsors/PE firms are targeting ~20% or more). This 20% IRR is sort of the cost of equity financing from the sponsor. Because of this high cost of capital for the LBO'd company (i.e., high discount factor in the PV calculation), the PV of the company is going to be lower. For this reason, when bankers compare the 4 valuation methods (ignoring for now any liquidation/replacement value measure), the LBO is usually going to spit out the lowest valuation.

You are correct when you say that to complete an LBO of a public company, a sponsor will have to pay a premium to the market price. However, an LBO doesn't make sense and a sponsor won't do an LBO (and pay the takeover premium) unless they expect to earn a 20% IRR on the deal. Private equity doesn't price deals based on the public market prices - it prices deal based on the expected IRR. We actually talk about deals like this at my firm...if we presented a 20% IRR deal to our investment committee and the company was more risky than the normal 20% deal we would show the committee, they might say something like "a 20% IRR is pricing this deal too low for the risk we're taking...we need to see at least 25-30% IRR to do this deal." When they say 20% IRR is priced too low, they're saying the IRR is too low which means that the purchase price we're assuming is too high. This is similar to how fixed income is quoted in terms of yield - a low yield means a bond is expensive...like a low IRR means that a LBO target is expensive, and a high yield means that a bond is cheap...like a high IRR means that you are buying the LBO target on the cheap.

Anyway, long story short, the "input" for the "LBO method" of valuation used in banking is the IRR which is ~20%. From that 20% IRR you back into a purchase price. You ignore the current market price in determining the value. If your LBO at a 20% IRR spits out a value that is way, way lower than the current market price, then the LBO doesn't make sense.

As far as increasing the value of the company through operational changes, it is true that you can do this but in reality, most PE returns are determined by the price you pay and not by the changes you make to the cash flows. The CEO of the public company could also make most of these operational changes and get the same results. Most large public companies are pretty sophisticated and will make these operational changes if the opportunities exist and are identifiable, so there won't be a lot of easy fixes for the PE buyer. In general, when you are running these valuation models at a bank, the cash flow projections you will use for the public company DCF and the LBO are going to be pretty similar (you, or your banking MD, won't know what sort of changes the PE firm could realistically make and if you really did know, you'd be running PE firms instead of banking)

1/21/11

^^The other posters here better appreciate the time you took to write all that. +1 for you.

1/20/11

DCF goes off management assumptions which are always overly optimistic is the explanation I heard.

1/20/11
rafiki:

DCF goes off management assumptions which are always overly optimistic is the explanation I heard.

Ya, but you still need to project a fully integrated three statement model for an LBO, it's not like your going to be using pessimistic assumptions, you are going to be targeting a specific IRR.

1/20/11

For interview purposes just look at Race's comment, that is what they are looking for. Don't talk about an LBO or DD or anything else.

1/20/11

It's amazing how many negative replies/thrown poop I've gotten on a question that most of you seem to disagree with. Wow.

1/20/11

Ya people are retarded and use this forum to talk about everything they learned 5 mins ago in financial managment. Just use exactly what Race said and you will be golden in interviews. Don't over analyze because i promise they are looking for those exact three answers, they don't want you to talk about a DD model or an LBO, and if you do that will open pandora's box of questions you are certainly not prepared for.

1/20/11
HFFBALLfan123:

Ya people are retarded and use this forum to talk about everything they learned 5 mins ago in financial managment. Just use exactly what Race said and you will be golden in interviews. Don't over analyze because i promise they are looking for those exact three answers, they don't want you to talk about a DD model or an LBO, and if you do that will open pandora's box of questions you are certainly not prepared for.

That's not true, I've been asked what the 4 valuation methodologies are in multiple interviews and the answer they were looking or was an LBO analysis to back into a purchase price. What would you use as the 4th if they asked for 4 and you don't want to mention an LBO?

1/20/11

Race's answer is what an accountant would say. Give that answer if they ask you for 3 (OP said 4) methods and you are interviewing at E&Y. Race's answer is what the accountants at my firm say when I tell them to do the FAS 157 valuations for my portfolio companies (afterwards, I take those valuations and throw them in the trash because they don't mean anything outside of the back office).

If you are interviewing with an investment bank and they ask for 4 methods, they are probably asking for 1) DCF; 2) public equity trading comps; 3) comparable precedent transactions; and 4) LBO (as said in the first reply).

Liquidation value makes sense and is good to consider if you are trying to make an intelligent investment with your own money. However, no M&A banker is going to go pitch an acquisition and show a football field with replacement/liquidation value on it because it's going to show a low-ass valuation and imply that the value of the acquisition target is way, way less than the seller's asking price. If the value of the acquisition target is way, way less than the asking price, then the deal doesn't make sense and the client should not do the deal and not pay the banker fees (oh yeah, banker's are always telling clients NOT to do the deal and not to pay them fees. *sarcasm*). This does not consider distressed/restructuring type situations where liquidation value would be more relevant.

HFFBALL, you should pause and think a bit before you call people retarded. I have never in my life taken a financial management course, but I have worked in banking and private equity. If you are interviewing for a job in investment banking, you should absolutely mention LBO in your response to the question in the OP because LBOs are very relevant in investment banking. It would also make sense to mention liquidation/replacement value as a 5th method (or as the 4th method if you are grouping equity trading comps and comparable transactions into one "market approach" method), but you won't be dealing much with that method in your day-to-day IB analyst job unless you work in a restructuring group.

HFFBALLfan123:

Ya people are retarded and use this forum to talk about everything they learned 5 mins ago in financial managment. Just use exactly what Race said and you will be golden in interviews. Don't over analyze because i promise they are looking for those exact three answers, they don't want you to talk about a DD model or an LBO, and if you do that will open pandora's box of questions you are certainly not prepared for.

1/20/11

DCF, Comps, Comp. acquisitions, and replacement value.

1/20/11
HFFBALLfan123:

DCF, Comps, Comp. acquisitions, and replacement value.

Thanks for that, appreciate your input. I'm not sure that is always the cut and dry case. I have responded LBO as the 4th valuation methodology in an interviewer, with the VP nodding his head and saying, "okay, that's the final one I was looking for."

1/20/11

I'm editing this to be less harsh because I don't want to be mean, and as the other people on the thread are showing it's not 100% cut and dried.

But I am seriously recommending you spend less time posting on WSO and more time trying to actually learn. The major issues with your posts about 13-Fs could have been solved with 5 minutes on wikipedia and google.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.

1/20/11

Kenny - respectfully I disagree.

1/20/11

SHORTmyCDO......are you a Dec. grad starting as an analyst early? Curious because I will be graduating in Dec. and hope to start early if possible (if I have an offer). If so is it a boutique or BB?

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger

1/20/11

Yes I am. I am starting at a boutique, but was able to land two BB interviews for early start dates within the last month, they are just taking forever to move forward in the process and my agreed start date is coming up at the boutique. I would recommend graduating early. I didn't really interview with many BB's during recruitment because I targeted more MM banks since I have a 3.3 from a nontarget, but had 3 super days for MM firms to start in July. Graduating in December, if anything will leave you with more options because a lot of banks will realize they under hired that year, people quit and you can always start in July.

1/20/11

If you can get an offer this summer after an internship, you shouldn't have a problem starting early.

1/20/11

Cool, thanks for the advice

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger

1/21/11

bankbank, I shouldn't have made a broad statement about all posters being retarded college kids. Just amazed that a simple question like what are the 4 valuation methods stirred this much debate....

1/21/11

bank...thank you so much for that post, SB for you. I think that is the most I've ever gotten out of a post on this site.

6/21/14

bumping this thread to see if there are any other inputs regarding the subject.

from macabacus: http://www.macabacus.com/valuation/methods

Snootchie Bootchies

8/26/14
8/26/14
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