Module IV· Interview EssentialsAdvanced
Question
What are the main differences between a DCF valuation and an LBO valuation of the same target?
Answer
What
DCF and LBO value the same target from different angles:
- DCF — "What is the company worth intrinsically?" Standalone view. The discount rate is WACC (typically 7–9% for the middle market). Output is EV.
- LBO — "What can a sponsor pay at most to reach its minimum IRR?" Buyer's view. The discount rate is the equity required return (typically 20%). Output is the maximum purchase price.
Convergence test
The DCF EV should theoretically equal the maximum LBO price if the sponsor IRR = WACC and the capital structure is identical. In practice the LBO price comes out 10–20% lower, because the sponsor's required return is higher than WACC.
Deep diveShow more details
Key differences in detail
| Aspect | DCF | LBO |
|---|---|---|
| Discount rate | WACC (7–9%) | equity required return (~20%) |
| Output | enterprise value | maximum purchase price |
| Debt financing | "optimal" assumption | explicitly modeled (tranches + repayment) |
| Terminal value | Gordon growth or exit multiple | explicit exit multiple at the holding period |
| Value drivers | NOPAT, FCFF, terminal growth, WACC | initial multiple, leverage, EBITDA growth, exit multiple, hold |
Application in practice
- DCF in strategic valuations (corporate M&A) and for trading comps.
- LBO as the standard for PE pitches and investment memos.
- In auctions BOTH methods are applied in parallel — the sponsor looks at the maximum LBO price and checks whether it can compete against strategics (DCF-based + synergies).
Pitch tip
In the interview, stress that an LBO model is NOT a valuation method in the classic sense — it models an acquisition's economics. The "fair value" comes from DCF or trading comps; the LBO price is a pricing constraint, not a value.