Leveraged buyout (LBO) analysis is a common valuation method used by investment bankers to estimate the potential return and value of a target company that is acquired using a large amount of debt. In this article, you will learn how to use a LBO analysis to value a company in five steps.
The first step is to project the target company's future cash flows based on its historical performance, industry trends, and growth assumptions. You need to forecast the income statement, balance sheet, and cash flow statement for the target company for a certain period, usually five to ten years. The key metrics to focus on are the earnings before interest, taxes, depreciation, and amortization (EBITDA), the free cash flow (FCF), and the net debt.
The second step is to determine the deal structure, which includes the sources and uses of funds for the transaction. The sources of funds are the equity and debt that the acquirer or the private equity firm uses to finance the deal. The uses of funds are the purchase price of the target company, the fees and expenses, and the repayment of existing debt. The deal structure also affects the capital structure and the cost of capital of the target company after the acquisition.
The third step is to calculate the internal rate of return (IRR), which is the annualized rate of return that the acquirer or the private equity firm expects to earn from the investment. The IRR is calculated by setting the net present value (NPV) of the cash flows to zero and solving for the discount rate. The cash flows include the initial equity investment, the annual FCF, and the exit value. The exit value is the estimated value of the target company at the end of the projection period, which can be based on a multiple of EBITDA or a discounted cash flow (DCF) analysis.
The fourth step is to perform a sensitivity analysis, which is a technique to test how the IRR changes with different assumptions and scenarios. The sensitivity analysis can vary the inputs such as the purchase price, the exit multiple, the growth rate, the debt level, and the interest rate. The sensitivity analysis can help identify the key drivers of value and the risks and opportunities of the deal.
The fifth and final step is to compare the IRR with the hurdle rate, which is the minimum required rate of return that the acquirer or the private equity firm demands from the investment. The hurdle rate depends on the risk profile, the opportunity cost, and the target return of the investor. If the IRR is higher than the hurdle rate, the deal is considered attractive and value-creating. If the IRR is lower than the hurdle rate, the deal is considered unattractive and value-destroying.