DCF is the framework everyone learns in business school and many practitioners distrust in private markets — too sensitive to assumptions, too vulnerable to the terminal-value flaw. The LBO model is the framework PE actually underwrites with. The VC method is a third thing entirely.
DCF — useful, with caveats
Build a 5–10-year cash-flow projection (unlevered free cash flow), select a terminal value (perpetuity growth or exit multiple — exit multiple is more honest in private markets), discount at WACC. The output is enterprise value; subtract net debt for equity value.
The DCF's value in PE is not as a price-finder — multiples do that — but as a sanity check. If the DCF says $300M and the market clears at $700M, the multiple is implying assumptions about exit price and growth that the deal team should make explicit. DCFs are also the primary tool in infrastructure and credit, where contracted cash flows make the technique more reliable.
The LBO model — the PE workhorse
Build assumptions: entry EV (e.g. 10x EBITDA), purchase price allocation (equity / debt / management rollover), debt schedule (term loan, mezzanine, revolver), 5-year operating projection (revenue growth, margin trajectory, working capital, capex), debt paydown waterfall (cash sweeps after mandatory amortisation), exit assumption (e.g. 9x EBITDA in year 5). Output: equity-IRR, MOIC (multiple of invested capital), and the returns bridge — the decomposition of equity value creation into multiple expansion, EBITDA growth, and debt paydown.
A representative bridge: $100M equity in, $250M equity out (2.5x). Of the $150M equity value created, $50M from EBITDA growth, $30M from multiple expansion, $70M from debt paydown. Reading the bridge tells you immediately what kind of deal it is: leverage-driven, growth-driven, or multiple-arbitrage-driven.
VC method and the alternative for early-stage
Pre-revenue companies have no meaningful EBITDA. The VC method works backwards from a hypothesised exit value: pick a 5–7 year exit value (revenue × multiple); apply target-IRR discounting back to today; that is the post-money valuation. Subtract the new investment to get pre-money. Crude, but it forces the explicit conversation about what has to be true at exit.
Scenarios and stress
Every IC presentation has at least three cases: downside (what if growth misses by 30%, what if margins compress by 200bps), base (the underwriting case), upside (what does management say). The base case is what the IC underwrites; the downside is the IRR floor; the upside is the bull case for steel-manning.