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:
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.
- 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:
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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