LBO, Other Valuation Methods, and Financing Strategy

A sponsor asks what price the cash flows can support, a strategic acquirer asks whether the deal adds to earnings, and a conglomerate asks what its segments fetch separately. Each question has its own valuation method, and the exam wants you to pick the right one.

A share is worth the cash it returns to you. For a dividend-paying stock, that cash is the dividend stream. The dividend discount model (DDM) discounts expected future dividends to present value.

The constant-growth (Gordon) form assumes dividends grow at a steady rate $g$ forever, discounted at required return $r$.

$$P_0 = \frac{D_1}{r - g}, \qquad D_1 = D_0 (1 + g)$$

The model only works when $r > g$; if growth meets or exceeds the discount rate, the formula breaks (a negative or infinite price). Two ratios feed it. Dividend yield is the annual dividend divided by price. Dividend payout ratio is dividends divided by net income; the complement is the retention (plowback) ratio. Growth links to retention through $g = \text{retention} \times \text{ROE}$.

Common mistakes

• Putting today's dividend in the DDM numerator. The Gordon model uses $D_1$, next year's dividend, equal to $D_0(1+g)$. Using $3.00 instead of $3.12 understates the price.
• Treating accretion as value creation. Accretion/dilution is an EPS screen only. A deal can be accretive yet destroy value; economic profit (NOPAT minus capital charge) is the value test.
• Swapping the QIB and qualified purchaser thresholds. A QIB owns $100 million in securities (Rule 144A); a qualified purchaser owns $5 million in investments (3(c)(7)). Reversing them is a classic trap.

Bottom line

• DDM values a stock as the present value of future dividends; the Gordon growth form is D1 divided by (r minus g)
• An LBO sets a valuation floor: it solves for the price a financial sponsor can pay to hit a target IRR at a given entry multiple and leverage
• Sum-of-the-parts values each segment on its own multiple, sums them, then subtracts net debt and corporate costs
• Accretion/dilution compares the acquirer's pro forma EPS to standalone EPS; stock deals dilute when the target P/E exceeds the acquirer P/E

Exam shortcut

DDM numerator is always next year. Price = $D_1 / (r - g)$, and $D_1 = D_0(1+g)$. If a question gives the current dividend, grow it one year before dividing. All-stock accretion test: lower target P/E means accretive, higher target P/E means dilutive. The acquirer wants to buy cheap earnings with rich shares.

The full lesson (about 3,335 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.

Learning objectives

• A9
• A10

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