Highest valuation, LBO vs DCF - The final answer. Perspectives on special situations.
Recently I had a interview for a FT position with a top EB. The question was to rank the 4 valuation methodologies. I said it depends, but still put LBO before DCF arguing that exploiting tax shields and financial engineering of the capital structure is possible to achieve a higher valuation if the capital structure in the DCF is not efficient. My point is that in some cases the Sponsor target IRR of 20-25% could still result in a lower WACC vs an inefficient capital structure (e.g. all equity).
Yes, I know that in general a LBO is a "floor" valuation given the high sponsor IRR has a substantial impact on WACC.
I would be interested on your perspective? Is there any chance my answer was acceptable although it represents a minority of the cases?
The standard answer is correct in practice, but in theory people confuse poor valuation practices with inherent valuation bias, and the latter is the one we should care about.
Multiples are DCFs, they are exactly the same thing just buried under a layer of extra assumptions. Obviously control premium is a factor for transaction comps.
LBOs should actually be higher than DCFs but lower than transaction comps. The reason is simple. PE firms don't have synergies so they don't pay any premium for that. If you sell to a PE firm it is necessarily lower than selling to a strategic buyer for this reason alone. However, PE firms are less risk-averse as part of their business model. LBOs require leverage, which is the same as swapping risk for returns. With less risk aversion than the market, you are willing to pay a higher price for the same amount of risk, i.e. higher valuation.
Why would anyone ever sell to a PE firm? Clearly, it is because PE firms believe they can buy an undervalued company and drive earnings growth or valuation expansion. The key here is that the company is still the same company, the valuation is the only thing that's not the same. In other words, don't confuse a tendency for bad valuation with an inherent downward bias in valuations.
If you were to rank them based on inherent valuation bias: 1) Transaction comps 2) LBO 3) Trading comp = DCF
This only applies if everyone has perfect valuation technique and the necessary information to value things perfectly exists.
Don't agree with the answer and the content. I think it really depends on your assumptions in the DCF.
(1) Multiples are DCFs? Not really, one valuation method is looking at the market's opinion and the other is looking at your opinion about the company. The "layer of extra assumptions" is actually quite important because the market values the company as stand-alone but , depending on the pretext, you may want to incorporate some things which the market is not aware of (i.e. if you expect synergies or whatever else depending on your proposed business plan)
(2) Strategics would almost certainly outbid PE firms in any process if the target is in the same industry and synergies are expected (unless PE firm has an asset that they can combine with the target). This also holds if a strategic gets higher market share after an acquisition. There could be a bunch of reasons really.
(3) "With less risk aversion..." - Why would PE firms necessarily be less risk averse? They are risk averse vs. who? I think it really depends on the PE as i've defeteinly seen some which are more prone to take risks which strategics can't afford to take, especially if they are public (corporate governance etc)
(4) PEs don't just buy undervalued companies - this is too theoretical as if i'm in a corp fin 101 class.
Of course in practical terms, this is what you would see if you were to line up all the valuations from different methods that have ever been done historically. I'm not disputing that. But that is confusing misvaluation with theoretical bias.
1) It can easily be shown that DCF = Multiple. Start with a single period DCF in per share terms:
Price = FCF/(r-g) - Net Debt
Then divide both sides by earnings
P/E = (FCF/E)/(r-g) - ND/E
So it is completely wrong to say that you are looking at the market's opinion about the company. You are assuming that comparable companies' cash flow margins, WACC, growth and leverage, are a good proxy for your company's. This is no different from having your own assumptions about that.
2) Completely agree. Which is why transaction comps should be higher than LBOs.
3) LBOs necessarily require lower risk aversion as compared to a non-leveraged buyout. Note that LBOs are defined by high leverage, otherwise it would just be a BO. A deal with that level of leverage immediately causes you to assume more financial risk compared to lower levels of leverage. So for the same company, you would necessarily need to buy it at a lower price, or you would need to value it at a higher price, the two are homomorphic. But if you bought it at the same price, it means you're willing to accept more risk, i.e. you would be less risk averse. Risk preference is typically not seen as linear, so you would need to value the company higher than you would typically adjust for under a standard discounted model.
4) Under the assumption of no synergies, there is no reason to ever buy a company at the price you have valued it for sale (before outflows). You would make zero profit. If you buy a company at a price higher than you valued it and still make profit, then it means your valuation was wrong. This doesn't change just because you lever your equity. In practice people tend to overpay, because their valuation was wrong. It's very difficult to have a perfect valuation, but it doesn't mean we should ascribe misvaluation to inherent bias.
You're absolutely right about everything, but don't get frustrated if the inexperienced crowd here doesn't immediately understand. It will take a lot of effort.
And yes, DCFs are just multiples. Everything that goes into a DCF (growth projections, margins, capex and NWC requirements, etc.) goes into a multiple.
All valuation is market based. Everything is based on comps, if done correctly. The terminal period, which carry most of the weight, is based on comps. The discount rate is based on comps.
To the extent that management's short-term projections (i.e., the super normal growth period) vary from comps, adjustments may need to be made to the discount rate. So on and so forth.
The fact that your data points show a range of values does not mean that an asset as multiple fundamental values. It just means that your valuation exercise is incomplete. As you continue your diligence, that range should narrow.
Valuation isnt simply about picking and plotting data points (though it may be for you, since you're an analyst). At some point, you'll have to reach a conclusion - select a value that falls within that range.
That analysis will be based on a deeper understand of the company (risk, growth profile, etc.) and a comparison to the comps (both public company and transaction).
That's a fair point. I would say the appropriate response to that question should be something along the lines of:
"Conceptually, the valuation should tie together across each methodology. That said, there are certain dynamics that should be considered between each indication.
For example, transaction comp multiples, if they reflect majority ownership transactions, will typically carry a premium for control. All other things equal, investors prefer a majority position over minority because it allows them to direct operations and to allocate free cash flow.
Public company valuation multiples, however, reflect a minority interest indication of value because of dispersed ownership among shareholders. Typically a control premium is applied to public company multiples to bridge the gap to that of transaction comps.
In addition, with respect to transaction comps, they may carry an additional premium over public company multiples because the buyer in the transaction is in a unique position to realize certain strategic synergies. In such a situation, the valuation analysis should consider public company multiples towards the higher end of the range to account for the higher growth and profitability characteristics of the transaction.
DCFs have the ability to be customized. They can reflect a minority or a majority ownership interest. In the case of an ownership interest, one would assume an optimal capital structure and would adjust line-item expenses that vary from market participant levels (i.e., management's salaries are too high). In a minority basis, no such adjustments would be made.
Each indication of value has it's own characteristics. However, it is the role if the analyst to conduct the proper diligence, analyze the data and to make the proper selection."
This, more or less, is the right answer. I do acknowledge however that most bankers are clueless and wouldn't get this.