Difference between LBO and DCF

Hi,

Could anyone tell me the key differences between lbo and dcf analysis. Purpose and technical aspects?

When Should I Use A DCF vs. an LBO?

The DCF and LBO are two different ways of valuing a company that are appropriate in different situations. Our users explain the difference between the methods below. Check out the appendix at the bottom for a review of the DCF and LBO analysis.

User @Extelleron" shared that an LBO is favored when the capital structure of the company is changing:

Extelleron - Hedge Fund Analyst:
The underpinnings of an LBO analysis and a DCF analysis are the same. An LBO type analysis models cash flows to and from various parties and from that you can calculate a rate of return to each party; a DCF models cash flows and a required rate of return, based on risk, in order to value a company or particular security.

I think the key reason an LBO analysis may be favored is that it is much more robust in dealing with a capital structure that changes over time. If you are doing a WACC DCF, it is very difficult and time consuming to accurately reflect capital structure changes in the discount rate.

Thus in a situation such as a PE buyout, where you will have a potentially complicated capital structure and leverage levels will change constantly, a model that outputs IRR is favored over one which requires you to have a discount rate as an input. Analyzing debt securities in a highly levered/distressed company is also another application for that type of analysis.

starlord888 - Risk Management Analyst:
  • DCF, you're discounting cash flows at each year + the terminal value
  • LBO, you're applying the cash flows to debt pay-down or sitting on it until you exit where you would pay down your debt and have the equity expansion

User @Extelleron", a hedge fund analyst, also shared:

Extelleron - Hedge Fund Analyst:
That a DCF does not account for how the cash flows are being used; whereas, the LBO looks at how you are using the cash being thrown off the business. The IRR is improved by the fact that you are using cash to pay off debt - the DCF value and return would be the same regardless of how you are using the cash flow from the business.

What is a DCF? What is an LBO?

Read more about the DCF model in the WSO Finance Dictionary.

Read more about the LBO model in the WSO Finance Dictionary

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In an LBO your end result is the IRR that sets your NPV = 0. A DCF gives an enterprise value based on cost of capital inputs (sort of like the IRR). An LBO typically has more focus and flexibility modeling debt/interest payback, and on the value delivered to each party involved (PE shop, debt holders, management, etc) while the DCF is concerned just about the stand alone firm.

Technically both should deliver the same answer if you put in the same inputs. So if your LBO gives you an IRR = 15%, you should be able to plug 15% in as your cost of capital you'll get an enterprise value = purchase price (NPV = 0).

Another point is that most LBOs model 5 years, and typically use an exit multiple. DCFs can model 5/10/15+ years, and can calculate the terminal value using the perpetuity formula.

 

Before dudes come in and try to flex...

Do some research and play around with them. There are a bunch of different templates on the internet. Create some fake scenarios and work with them.

I found this is the best way to learn.

How old are you, BTW?

 

Not sure why the first answer is getting shit on. A bit academic and simplified but the point is, the underpinnings of an LBO analysis and a DCF analysis are the same. An LBO type analysis models cash flows to and from various parties and from that you can calculate a rate of return to each party; a DCF models cash flows and a required rate of return, based on risk, in order to value a company or particular security.

I think the key reason an LBO analysis may be favored is that it is much more robust in dealing with a capital structure that changes over time. If you are doing a WACC DCF, it is very difficult and time consuming to accurately reflect capital structure changes in the discount rate.

Thus in a situation such as a PE buyout, where you will have a potentially complicated capital structure and leverage levels will change constantly, a model that outputs IRR is favored over one which requires you to have a discount rate as an input. Analyzing debt securities in a highly levered/distressed company is also another application for that type of analysis.

 

My thought is as follows, assuming you have very simplified and identical inputs:

DCF, you're discounting cash flows at each year + the terminal value LBO, you're applying the cash flows to debt pay-down or sitting on it until you exit where you would pay down your debt and have the equity expansion

The total 'cash' reaped should be the same in both cases. Wouldn't the DCF still yield a higher value? Because you're receiving the cash flows and reaping value on your investment earlier (with each year) in the DCF analysis. Meanwhile, for the LBO analysis, you're reaping ALL your value at the end.

 

My thought is as follows, assuming you have very simplified and identical inputs:

DCF, you're discounting cash flows at each year + the terminal value LBO, you're applying the cash flows to debt pay-down or sitting on it until you exit where you would pay down your debt and have the equity expansion

The total 'cash' reaped should be the same in both cases. Wouldn't the DCF still yield a higher value? Because you're receiving the cash flows and reaping value on your investment earlier (with each year) in the DCF analysis. Meanwhile, for the LBO analysis, you're reaping ALL your value at the end.

 
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