What Does Leveraged Buyout Valuation Method (LBO) Mean?
A leveraged buyout (LBO) valuation method is a type of analysis used for valuation purposes. The alternative sources of funds are analyzed in terms of their contribution to the net IRR. This analysis is carried out in order to project the enterprise value of a company by the financial buyer that acquires it. When a company is purchased with significant amounts of borrowed money, keeping its assets as collateral and using its cash flows can be a way to service the debt. In this case, the company's debt acts as a lever to improve returns on investment.
Divestopedia Explains Leveraged Buyout Valuation Method (LBO)
Financial buyers benefit by keeping the ratio of debt to equity very high. Compared to equity, debt has a lower cost of capital, so it helps to improve return on investment. The financial buyers acquire a company, fix it up, and then sell it. Thus, a leveraged buyout is an accepted form of business growth. By carrying out an analysis, buyers can determine the maximum purchase price that should be paid depending on different leverage levels and associated returns.
The analysis involves the following steps:
- The sources and uses of the funds for purchasing the firm are identified in terms of equity and debt;
- The firm's existing balance sheet is modified (pro-forma balance sheet) to reflect the transaction and the new capital structure; and
- An integrated cash flow model is created to project the firm's income and cash flow over a period of time.
Companies that are very stable and have recurring cash flows can safely have a very high debt volume, up to 90% or more than the purchase price. However, the normal range would be 40-50% of the purchase price. When firms do not generate sufficient cash flows to service their debts (an over-leveraged buyout), a high debt-to-equity ratio may lead to insolvency or require debt-to-equity swaps, which would amount to relinquishing control. Because of this, steady cash flow (to support the relatively high interest expense in a highly leveraged buyout) is a very important factor.