The leveraged buyout transaction is orchestrated by a private equity firm also called a financial sponsor or group of private equity firms also called a private equity group or a consortiumwhich will take ownership own the equity of the business after the acquisition has been completed.
DCF is a direct valuation technique that values a company by projecting its future cash flows and then using the Net Present Value NPV method to value those cash flows. In a DCF analysis, the cash flows are projected by using a series of assumptions about how the business will perform in the future, and then forecasting how this business performance translates into the cash flow generated by the business—the one thing investors care the most about.
DCF should be used in many cases because it attempts to measure the value created by a business directly and precisely. It is thus the most theoretically correct valuation method available: DCF is probably the most broadly used valuation technique, simply because of its theoretical underpinnings and its ability to be used in almost all scenarios.
However, DCF is fraught with potential perils. If even one key assumption is off significantly, it can lead to a wildly different valuation.
This is quite possible, given that DCF involves predicting future events forecastingand even the best forecasters will generally be off by some amount. Therefore, DCF should generally only be done alongside other valuation techniques, lest a questionable assumption or two lead to a result that is substantially different from what market forces are indicating.
When doing a DCF analysis, a useful checklist of things to do has a mnemonic that is easy to remember: Validate key assumptions for projections. Sensitize variables driving projections to build a valuation range. When performing a DCF analysis, a series of assumptions and projections will need to be made.
Ultimately, all of these inputs will boil down to three main components that drive the valuation result from a DCF analysis. Free Cash Flow Projections: The cost of capital Debt and Equity for the business.
This rate, which acts like an interest rate on future Cash inflows, is used to convert them into current dollar equivalents. The value of a business at the end of the projection period typical for a DCF analysis is either a 5-year projection period or, occasionally, a year projection period.
The DCF valuation of the business is simply equal to the sum of the discounted projected Free Cash Flow amounts, plus the discounted Terminal Value amount.
There is no exact answer for deriving Free Cash Flow projections. It is very easy to increase or decrease the valuation from a DCF substantially by changing the assumptions, which is why it is so important to be thoughtful when specifying the inputs. We will discuss WACC calculations in detail later in this chapter.
Terminal Value is the value of the business that derives from Cash flows generated after the year-by-year projection period. It is determined as a function of the Cash flows generated in the final projection period, plus an assumed permanent growth rate for those cash flows, plus an assumed discount rate or exit multiple.
More is discussed on calculating Terminal Value later in this chapter. An Unlevered DCF involves the following steps:*Investment banking and corporate finance services are offered through First Analysis Securities Corporation ("FASC" or "First Analysis Securities"), a subsidiary of First Analysis Corp.
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Get the latest news and analysis in the stock market today, including national and world stock market news, business news, financial news and more. DCF is a direct valuation technique that values a company by projecting its future cash flows and then using the Net Present Value (NPV) method to value those cash flows.
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