fin1 - DCF, LBO and the different valuation methods in Finance
- Investment, M&A

DCF, LBO and the different valuation methods in Finance

Valuation is a key component in Corporate Finance in general. It is universally important, whether you are a startup looking to raise seed capital or a large company intending to go public. In today’s world, it defines companies and their prestige.

The first thing to understand about valuation is unlike most financial concepts, valuation is not entirely mathematical and objective. The reason is because valuation is based on future cash flows. You are predicting how your company will perform over the next 10 years. Hence it involves numerous assumptions.

Depending on the level of assumptions involved and the amount of data that is available, you can use different methods for valuation. The standard two methods include market multiples and discounted cash flow (DCF) methodologies. Additionally, there are Leveraged buyout (LBO) valuations.

Less than a decade back, Strathmore Minerals sold assets in Pine Tree-Reno Creek, Wyoming, to NCA Nuclear Inc. for $30M. While we don’t have full details on this, we were informed that NCA Nuclear Inc. used an LBO methodology to value the asset. The reason behind the LBO methodology was that there was significant amount of debt that was used to purchase the asset.

fin2 - DCF, LBO and the different valuation methods in Finance

Let us assess when each method is used. Market multiples are used in the comparable method, where you use a multiple on projected EBITDA to derive valuation. They can be used in situations where a minority share of the company is sold or new equity issued, and there is an accurate comparable that is available.  Comparable method is used in Equity Capital Markets (ECM) and M&A transactions

The DCF method is usually the most precise methods, and is used when you have an indication of future cashflows and interest rates. It does involve a huge number of assumptions and whatever it brings in terms of precision, it loses in terms of accuracy. The DCF method is used everywhere, provided future data is available.

And finally, LBO valuation is used in acquisition scenarios where a large amount, of the order of 50%-80% of the total price, is used to fund the acquisition. Private equity firms use this extensively in their acquisitions.

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