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How to answer: Which valuation method gives the highest valuation?
The short answer: it depends.
Comparable transactions and DCF are both on the higher end
Comparable companies and LBO are both on the lower end
This question is part of your valuation questions in an Investment Banking interview. When answering this question, you would try to elaborate on the different factors driving the valuation levels of the respective valuation methods. It’s less about having the order correct. In reality, the order changes all the time.
This is the rough order and the rationale:
Comparable transaction analysis – In general, comparable transactions > comparable companies. Comparable transactions include the premium paid in a competitive bidding process and should yield the highest valuation in theory. If comparable transactions are too old, they may also have lower valuation levels due to differences in inflation and general macroeconomic outlook compared to today
DCF – Valuation levels of a DCF are heavily driven by the underlying business plan and assumptions regarding WACC and terminal value. So, there are a lot of levers to drive up the valuation here. Most of the time, it’s a very ambitious business plan of the management team going forward
Comparable company analysis – Can have a higher valuation if one of your peers is blown out of proportion. If this happens, the peer group is up for debate. How comparable is this peer company? Do the margins and growth outlook match? Did something exceptional happen that year? If that peer company is not comparable, you will exclude it, bringing the valuation back down again. In other words, chances are relatively low for a comparable company analysis to yield the highest valuation unless the peer group does not match the target company
LBO – An LBO usually yields a lower valuation. It is a leveraged buyout driven by IRR rather than strategic value. After all, the private equity fund wants to sell the company for a profit down the road. Here the numbers of the entire acquisition must add up. The cheaper your purchase price is, the more wiggle room you have to turn a profit when selling. Private equity funds usually have a hurdle rate of ca. 20% IRR.
Answering this question should take you around 2-3 minutes in an actual interview situation.
BONUS: If you could only pick one valuation method, which one would you pick?
The short answer: the comparable company analysis.
Why comparable company analysis? The multiple is forward-looking and reflects the growth outlook of industry peers. The valuation hinges on the quality of the peer group, which can be easily checked and challenged
Why NOT comparable transactions? It’s backward-looking and the multiples may be tainted by overblown transaction premium, inflation and macroeconomic outlook then. In other words, if your comparable transactions are too old, they are not good of a reference point. And finding exactly matching deals that are not too old is rather difficult
Why NOT DCF? The problem here is the underlying business plan. You need much more information and a full commercial due diligence to validate the projections and growth outlook. This is too much for a quick valuation
Why NOT LBO? Same reason as why not DCF. You need to understand the assumptions of the underlying business plan. The business plan runs through the LBO model, which then spits out an IRR at the end. If the growth projections are not accurate, your entire model and valuation is not accurate
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