When does a DCF produces a lower valuation than the LBO
I came across this interview question and was not sure:
"When does a DCF produces a lower valuation than the LBO"
Some help?
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The mistake is people often reply "low growth" to this question. The correct answer is not low growth, but negative growth. Specifically, a declining industry.
~70%+ of value estimated by a DCF is embedded in TV w/ growth in perpetuity
An LBO's view on the future beyond the ~5 yr. time horizon is implied at best and traditional value-oriented businesses don't have to rely on multiple expansion to get great returns. And even still, an exit multiple can be based on other determining factors such as competitive tension, idiosyncratic dynamics, etc
Ex. Something like the newspaper industry which has clearly experienced / experiencing declining market share of read media (and might be extinct in 30y) but has incredible operating leverage & great margins = excellent LBO candidate and potential extinction is so far away that someone else is perfectly happy buying the business in 5y when you exit. Here, a DCF approach under-weighs the value of strong interim cash flow and over-weighs zero/negative growth extremely punitively (esp if you use something like the DDM method)
Agree with answer above, though perhaps the tldr is "when the wacc is higher than your lbo hurdle rate".
Agree - a nit, but I think it should be COE vs. IRR (i.e. a PE firm's COE) to be apples-to-apples. If this is for PE interview prep, I assume this is the answer they are looking for.
I actually disagree with the answer above about declining industry, however, as the scenario provided is not really apples-to-apples across the LBO and DCF scenarios - it's basically arbitrarily making the exit multiple / TV in an LBO scenario to be higher than in a DCF scenario, which is the only reason the value of the business is higher. The interim cash flows in a DCF scenario are more valuable than in an LBO scenario, assuming COE < Return hurdle. For TV, you don't have to use perpetuity method in a DCF, you could use a market multiple in your exit value / TV as well or just project out cashflows for a longer period of time (which seems to be what's happening in the LBO scenario). Also, in an LBO scenario in an obviously declining industry, you should model multiple contraction to be intellectually honest.
The way I think about it, an LBO is really just a form of a regular DCF valuation with leverage assumptions that are typically very aggressive, the only difference really being a DCF is seeing what value is implied by a specific discount rate, an LBO is seeing what specific value you need to pay to hit a specific return / discount rate. But really the same thing at the end of the day - you project out the CFs to the equityholder and discount them to determine what you're willing to pay for them. So basically, it's really only the discount rate that matters at the end of the day.
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