400Q Guide Error?
My issue is with the awnser to the following question:
Would an LBO or DCF give a higher valuation?
Technically it could go either way, but in most cases the LBO will give you a lower valuation.
Here’s the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year – you’re only valuing it based on its terminal value.
With a DCF, by contrast, you’re taking into account both the company’s cash flows in between and its terminal value, so values tend to be higher.
My take: In an LBO the cashflows between purchase and exit clearly deliver value, they reduce the debt end thereby increase the value of the equity the sponsor owns, so this can't be the reason for the valuation difference. I had heard a different explaination: For a DCF you use WACC as a discounting measure, the closest figure from an LBO for that is the IRR, although its more like
Different use, but same concept and the IRR is usually 20%+, which the cost of equity would barely never hit and then that decreases the PV of the company ceteris paribus the sponsor is able to pay less
The point is that, mechanically, in a DCF model, you include the value from cash flows along the way into the overall value of the company. In an LBO model, only the terminal value is compared to the entry price. This leads to a lower valuation most of the time. I don't think the question is getting at the actual value driven by incremental cash flows, but instead simply the mechanics of the model. Hope this is helpful.
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