Would an LBO or DCF typically provide a higher valuation?

• A. LBO yields a lower valuation because you do not receive cash flows between Year 1 and the terminal year
• B. DCF yields a lower valuation because it discounts near-term cash flows
• C. LBO yields a higher valuation because it uses leverage to boost returns
• D. DCF yields a higher valuation because it includes terminal value

Answer: (D)

In a valuation, the terminal value is a major driver in a DCF because it represents the value of cash flows beyond the explicit forecast horizon and is discounted back to today. When you add the present value of the explicit cash flows to the present value of the terminal value, the overall enterprise value can be sizable, often larger than what an LBO implies.

An LBO relies on financing structure and a required equity IRR. Leverage can boost returns to equity, but debt capacity and repayment constraints limit how high the value realization can be. This makes the equity value from an LBO typically lower than the enterprise value suggested by a DCF, especially when the terminal value is substantial. That’s why the DCF approach tends to yield a higher valuation in standard practice.