Highest valuation, LBO vs DCF - The final answer. Perspectives on special situations.

I'd advise you against telling an interviewer that if two valuation methodologies rest on two different sets of projections that the one with the more optimistic assumptions will yield a higher valuation...

What's the source for this, looks like good guide.

b43b6b7b82b87:

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 were corrected because that's just wrong... obviously, it will depend a lot on assumptions but all else held equal an LBO will give lower valuations than a DCF

This is probably the best explanation as to why from this thread: https://www.wallstreetoasis.com/forums/four-valuation-methods

bankbank:

I'm going to try and explain this simply, but it would be better explained with some math and modeling... Apologies in advance for being long-winded.

Also, a "financial sponsor" is a financial buyer (a private equity or VC firm, as opposed to a strategic/corporate buyer). So when I mention "financial sponsor" or "sponsor," I am referring to the PE firm doing the LBO.

An LBO valuation is akin to a DCF valuation, except the costs of capital are higher. When bankers talk about the LBO as a valuation method, they are thinking of the "valuation" in terms of the financial sponsor's ability to buy the company and generate a 20%+ IRR (most sponsors/PE firms are targeting ~20% or more). This 20% IRR is sort of the cost of equity financing from the sponsor. Because of this high cost of capital for the LBO'd company (i.e., high discount factor in the PV calculation), the PV of the company is going to be lower. For this reason, when bankers compare the 4 valuation methods (ignoring for now any liquidation/replacement value measure), the LBO is usually going to spit out the lowest valuation.

You are correct when you say that to complete an LBO of a public company, a sponsor will have to pay a premium to the market price. However, an LBO doesn’t make sense and a sponsor won’t do an LBO (and pay the takeover premium) unless they expect to earn a 20% IRR on the deal. Private equity doesn’t price deals based on the public market prices – it prices deal based on the expected IRR. We actually talk about deals like this at my firm…if we presented a 20% IRR deal to our investment committee and the company was more risky than the normal 20% deal we would show the committee, they might say something like “a 20% IRR is pricing this deal too low for the risk we’re taking…we need to see at least 25-30% IRR to do this deal.” When they say 20% IRR is priced too low, they’re saying the IRR is too low which means that the purchase price we’re assuming is too high. This is similar to how fixed income is quoted in terms of yield - a low yield means a bond is expensive…like a low IRR means that a LBO target is expensive, and a high yield means that a bond is cheap…like a high IRR means that you are buying the LBO target on the cheap.

Anyway, long story short, the “input” for the “LBO method” of valuation used in banking is the IRR which is ~20%. From that 20% IRR you back into a purchase price. You ignore the current market price in determining the value. If your LBO at a 20% IRR spits out a value that is way, way lower than the current market price, then the LBO doesn't make sense.

As far as increasing the value of the company through operational changes, it is true that you can do this but in reality, most PE returns are determined by the price you pay and not by the changes you make to the cash flows. The CEO of the public company could also make most of these operational changes and get the same results. Most large public companies are pretty sophisticated and will make these operational changes if the opportunities exist and are identifiable, so there won’t be a lot of easy fixes for the PE buyer. In general, when you are running these valuation models at a bank, the cash flow projections you will use for the public company DCF and the LBO are going to be pretty similar (you, or your banking MD, won’t know what sort of changes the PE firm could realistically make and if you really did know, you’d be running PE firms instead of banking)

Dude - I really do commend you for thinking so much and clearly so hard about this, but you are starting to sound like the economist trapped at the bottom of a well whose first step to getting out is "assume a ladder."

If a company is "undervalued" then of course the LBO is going to look better. If your DCF assumptions are higher than the ones contemplated by the comps, well yeah, of course that's going to yield a higher valuation. If your WACC is based on a hideously inefficient cap structure it's of course going to depress the DCF. But a valuation - if done at all correctly - accounts for all those things. Otherwise it's apples to oranges.