Difference between LBO and DCF

Carlsen's picture
Rank: Monkey | banana points 35

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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Comments (18)

Oct 21, 2014

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.

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Oct 22, 2014

wtf??

Oct 22, 2014
Whiskey5:

wtf??

Nov 24, 2014

Not different except one is transaction specific whilst the other is not.

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Dec 1, 2014

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?

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Dec 1, 2014

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.

    • 1
Dec 18, 2014

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.

Dec 18, 2014

What? You're still getting the cash flows every year in an LBO, just using it to pay down debt...

Dec 18, 2014

Yeah exactly, so as the sponsor, you're delaying the receipt of cash flows to when you ultimately sell the business and reap the value of those cash flows in the form of the increased equity balance. From the sponsor/equity holder's perspective, you've only received the benefit of the cash flow once, which is at the end.

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Dec 18, 2014

Yeah exactly, so as the sponsor, you're delaying the receipt of cash flows to when you ultimately sell the business and reap the value of those cash flows in the form of the increased equity balance. From the sponsor/equity holder's perspective, you've only received the benefit of the cash flow once, which is at the end.

Dec 18, 2014

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.

Jan 3, 2015
  1. IRR can be seen as the discount rate where your NPV is 0. The good part about IRR is that you dont have to compute WACC and you can use the IRR to compare between 2 potential companies to invest in. WACC takes into the cost of debt, cost of equity as well as the opportunity costs of investing into the company. That means that you should only pursue the investment when the IRR > WACC.
  2. Money today do worth more than the money tomorrow. So, within a time frame of 5 years, the money at year 4 is definitely worth more than the money at year 5. For your example, you need to compare it with another scenario with a similar time frame e.g. if you have an investment of 5 year time frame versus another investment with a 4 year time frame + an investment that you can get at your 4th year.
  3. Some PE firms can act as both a financial sponsor and strategic buyer through the buy and build strategy where they buy a portfolio company and use it to acquire smaller companies.