How to answer "pitch me a stock"

Multiples aren’t necessarily a valuation method. They are standardized financial ratios used when applying the Comparable Company Analysis or a Precedent Transactions Analysis valuation methods.Both of these methods fall under market approach or relative valuation. This valuation strategy determines value by comparing companies to each other using standardized metrics or "multiples". That’s in contrast to absolute valuation methods that attempt to find a company's intrinsic value by examining its fundamentals, like cash flows, in isolation, such as Discounted Cash Flow (DCF) analysis. Why Are Valuation Multiples Important?Valuation multiples are needed when comparing companies because absolute financial figures like revenue or profit can be misleading. They don’t account for differences in company size, profitability margins, growth prospects, risk profiles, and industry-specific characteristics. Valuation multiples solve this problem with standardization. That happens by dividing a company’s total worth, either the market capitalization or the enterprise value, by common financial metrics like sales, earnings, and book value.The result is a ratio or multiple that makes direct and meaningful comparisons possible. For example, instead of comparing a $1 billion market cap company with $100 million in profit to a $100 million market cap company with $10 million in profit (absolute figures), we can compare their Price-to-Earnings (P/E) ratios:Company 1: P/E = $1 billion / $100 million = 10x (10 times its earnings)Company 2: P/E = $100 million / $10 million = 10x (10 times its earnings)Even though their absolute sizes and profit figures are different, the P/E ratio shows they are valued similarly by the market relative to their earnings.  What Are Common Valuation Multiples The popular valuation multiples are grouped into two main categories: Equity Value Multiples These multiples divide the company's market capitalization or stock price, by a financial metric that pertains to equity holders, such as earnings, sales, and book value. Equity multiples can be affected by changes in capital structure even if the enterprise value remains the same. However, they are easy to calculate and are available through most financial newspapers and websites.1. Price-to-Earnings (P/E) RatioThe P/E ratio shows how much investors are willing to pay for each dollar of a company's earnings. A higher P/E ratio might suggest that investors have high growth expectations for the company or that the stock is overvalued compared to its earnings. P/E Ratio = Price Per Share ÷ Earnings Per Share (EPS)For example: If Company A's stock trades at $50 and its EPS is $5, its P/E ratio is 10x. This means investors are willing to pay $10 for every $1 of current earnings.The next step is to compare this 10x P/E ratio to the P/E ratios of similar companies, its own historical P/E, or industry averages to determine if Company A is relatively overvalued, undervalued, or fairly valued.2. Price-to-Book (P/B) RatioBook Value is the net asset value of a company (total assets minus total liabilities). Thus, the multiple compares a company's market value to its book value, or the value of its net assets according to its balance sheet. P/B Ratio = Share Price ÷ Book Value Per ShareP/B works best for:Financial institutions like banks and insurance companiesAsset-heavy businesses like manufacturing, real estateCompanies with significant tangible assetsHowever, P/B becomes less relevant for companies with substantial intangible assets, like brands, patents, or intellectual property. A lower P/B ratio might suggest undervaluation or that the market has concerns about the company's assets3. Price-to-Sales (P/S) RatioThe P/S ratio is similar to EV/Revenue but uses market capitalization instead of enterprise value. It indicates how much investors are willing to pay for each dollar of the company's revenue.P/S Ratio = Market Capitalization ÷ Annual Revenueor for per-share values:P/S Ratio = Share Price ÷ Sales Per Share (Total Revenue divided by the number of outstanding shares)4. PEG Ratio (Price/Earnings to Growth)The Price/Earnings to Growth (PEG) Ratio is another common valuation multiple that builds upon the P/E ratio by factoring in a company's expected earnings growth rate.PEG Ratio = P/E Ratio ÷ EPS Growth Rate (%)A PEG of 1.0 might indicate a fair valuation relative to growth. Below 1.0 might suggest undervaluation, while above 1.0 might indicate overvaluation.Enterprise Value MultiplesThese multiples divide the company's enterprise value (market capitalization + net debt) with a financial metric that represents the value available to all capital providers, both debt and equity holders. They are less impacted by accounting differences, and allow for direct comparisons among various companies regardless of capital structures. 1. Enterprise Value-to-Revenue (EV/Revenue)This multiple compares the total value of the company (equity and debt) to its total sales. It's useful for companies that may not be profitable yet or have cyclical earnings, as revenue is generally more stable.EV/Revenue = Enterprise Value (Market Capitalization + Total Debt - Cash & Cash Equivalents) /Revenue2. Enterprise Value-to-Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA)This multiple looks at the total company value relative to its operating profitability before non-cash expenses and financing costs. EBITDA, Earnings Before Interest, Taxes, Depreciation, and Amortization, is often used as a proxy for cash flow. This multiple is popular because it helps to normalize for differences in capital structure (debt), tax rates, and accounting methods (depreciation and amortization).EV = Market Capitalization + Total Debt - Cash and Cash EquivalentsEV/EBITDA = Enterprise Value ÷ EBITDAFor example, if Company C has an EV of $1 billion and EBITDA of $200 million, its EV/EBITDA is 5x.Advantages of EV/EBITDA multiple: Accounts for debt unlike P/ELess affected by accounting differences in depreciationEasier to compare companies with different tax situations3. EV/EBIT EV/EBIT is similar to EV/EBITDA but accounts for the capital intensity of the business by including depreciation. It shows the relationship between the total value of the company and its operating profitability. It tells you how many dollars an investor would need to pay for each dollar of the company's operating earnings.EBIT: Earnings Before Interest and Taxes, also called operating profit.Enterprise Value (EV): The total value of the company, including its market capitalization (equity value), debt, and preferred stock, minus cash and cash equivalents. It's the theoretical cost to acquire the entire business.EV/EBIT= Enterprise Value (EV) / Earnings Before Interest and Taxes (EBIT) Common Valuation Multiples Interview Questions 1. Why might investors prefer EBIT multiples over EBITDA multiples?The primary concern with EBITDA is that it might present an overly optimistic view of profitability by treating capital expenditures as if they were somehow optional or free. However, in reality they are necessary ongoing costs for many businesses.So, some investors, including notable value investors like Warren Buffet, prefer EBIT multiples because:EBITDA can potentially mask capital expenditure requirements by removing depreciation.Depreciation is a real economic cost for businesses with physical assets.EBIT provides a clearer connection to capital expenditures through depreciation expenses.Companies with high depreciation expenses typically require ongoing capital expenditures to maintain operations.The gap between EBIT and EBITDA becomes particularly significant in capital-intensive industries.2. What are the key differences between P/E, EV/EBIT, and EV/EBITDA multiples, and when is each most appropriate?These three financial ratios all measure a company's profitability, but they serve different purposes.P/E (Price-to-Earnings) Ratio is calculated using net income, which includes the impact of interest payments. It’s affected by a company's capital structure, debt-to-equity ratio, and it’s most suitable for financial companies (banks, insurance firms) where interest expenses are fundamental to their business model. EV/EBIT (Enterprise Value-to-Earnings Before Interest and Taxes) is capital structure-neutral, making it useful for comparing companies with different debt levels. It includes depreciation and amortization costs and provides a more realistic picture of operational profitability in industries with significant fixed assets. It’s preferred for manufacturing businesses and other capital-intensive industries where equipment depreciation reflects a real economic cost.EV/EBITDA (Enterprise Value-to-Earnings Before Interest, Taxes, Depreciation, and Amortization) is also capital structure-neutral but excludes depreciation and amortization. It’s better suited for technology companies and service businesses with fewer physical assets. 3. What industry-specific valuation multiples are used beyond traditional metrics?Different industries require specialized valuation multiples that better reflect their unique business models:Technology/Internet Companies:EV/Unique VisitorsEV/PageviewsRetail and Airlines:EV/EBITDAR (adds back rental expense)Used to normalize companies that own versus rent their facilitiesEnergy Companies:EV/EBITDAX (adds back exploration expenses)EV/Daily ProductionEV/Proved ReservesReal Estate Investment Trusts (REITs):Price/FFO (Funds From Operations)Price/AFFO (Adjusted Funds From Operations)4. Why do we add debt and subtract cash when calculating Enterprise Value?Debt is added because the acquirer assumes the company’s debt, and cash is subtracted because it can be used to pay down debt, reflecting the net cost to acquire the company. 5. How do you determine the appropriate multiple to use when valuing a company? The choice depends on several factors, particularly the company’s profitability, growth stage, and industry. Young, high-growth firms without stable earnings are often valued using revenue-based multiples like the price-to-sales (P/S) ratio.Established companies with reliable earnings are better suited for metrics like EV/EBIT or EV/EBITDA. Industry-specific characteristics also play a role – for example, real estate and energy companies often require specialized multiples.It’s also important to ensure there is enough comparable market data to interpret the multiple meaningfully.👉 In our Case Library, you can practice the most important finance concepts. We've picked out two valuation cases for you:

A Leveraged Buyout (LBO) Model is a popular financial analysis tool for private equity firms, typically built in Excel. It’s used to assess whether a company is worth acquiring primarily with debt. In an LBO, private equity firms or investors purchase a company by combining equity, or their money, with debt. The model projects the target company's financial performance, including revenue, expenses, and cash flow, post-acquisition to show how its cash flow will be used to service and pay down the large amount of debt taken on. The main purpose of building an LBO model is to determine the potential returns for the equity investors, like the private equity firm, by calculating metrics such as Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC) at the time of an eventual sale or exit. It also helps assess the company's ability to handle the debt burden. How to Build a Basic LBO ModelFirst, it's essential to understand the building blocks of the model and what each step aims to achieve. So let’s have a look at the key components of an LBO model:Step 1: Make Key AssumptionsThe first step of building an LBO model is to make assumptions about important factors like the following:Purchase Price: The total amount of money paid to acquire the target company. The purchase price is based on a valuation metric like Enterprise Value (EV), which represents the total value of the company, including debt and equity.Debt/Equity Ratio: This specifies the proportion of debt versus equity used to finance the purchase. A higher ratio indicates more leverage.Interest Rate on Debt: The cost of borrowing the debt, expressed as a percentage.You also estimate operational metrics such as revenue growth and margins or profitability as a percentage of revenue. These assumptions provide the foundation for evaluating the feasibility and returns of the deal.Step 2: Create a Sources and Uses SectionThe next step is to build a sources and uses table, which outlines how the acquisition will be financed and where the money will go. Sources represent the capital used to fund the purchase, including equity and debt.Uses show how this capital is allocated. These areas include the purchase price, transaction fees, and debt repayment. This section also calculates the equity contribution, or the amount of cash investors need to provide.Step 3: Adjust the Balance SheetAfter determining financing, you modify the company’s balance sheet to reflect the new capital structure. This involves adding the newly acquired debt and equity to the liabilities and equity side, while balancing the assets side by including items like goodwill. That is the premium paid over the company’s book value. These adjustments ensure the balance sheet remains accurate post-transaction where:Assets = Liabilities + EquityStep 4: Project Financial StatementsThis step is all about forecasting the company’s future performance by projecting its income statement, balance sheet, and cash flow statement. Key components include estimating cash flows, accounting for interest payments (the cost of borrowing), and modeling debt repayment over time. Strong cash flow is essential for covering debt obligations and ensuring the transaction’s success.Step 5: Calculate Returns and Exit AssumptionsThe final step is to estimate the potential returns. You make assumptions about the exit strategy, such as selling the company after a few years at a multiple of its EBITDA (earnings before interest, taxes, depreciation, and amortization). Using these assumptions, you calculate metrics like the internal rate of return (IRR), which measures the profitability of the investment for equity holders.Another profitability metric is Multiple on Invested Capital (MOIC) which calculates how many times the initial investment is returned. For example, a 2.0x MOIC means for every $1 invested, $2 was returned. Common Leveraged Buyout (LBO) Model Interview Questions To help you prepare, we’ve gathered some typical LBO interview questions. These examples will give you a good sense of what might come up and are a great way to practice and build confidence ahead of your interview.1. What makes a company a good LBO candidate?The most important criteria when checking if a target company is an ideal LBO candidate is stable cash flows. That’s because the acquiring company uses the free cash flows to pay down the debt principal and interest. Other factors include: Having assets that can be used as debt collateralA low purchase price and low-risk industryNot have a huge need for ongoing or other investments such as CapExHave opportunities to decrease costs and increase margins2. What is the Internal Rate of Return (IRR) of the following investment?A private equity firm acquires a company with $50 million in EBITDA at an 8x multiple, using 70% debt and 30% equity. By Year 4, the company’s EBITDA has grown to $80 million, but the exit multiple has dropped to 7x. Over the holding period, $150 million of the debt is repaid and there’s no extra cash on hand. Let’s break it down step by step:1. Purchase PriceEBITDA × Entry Multiple = $50 million × 8 = $400 million2. Capital Structure at EntryDebt (70%) = $280 millionEquity (30%) = $120 million 3. Exit ValueEBITDA × Exit Multiple = $80 million × 7 = $560 million4. Equity Value at ExitRemaining Debt = $280 million – $150 million = $130 millionEquity Value = Exit Value – Remaining Debt = $560 million – $130 million = $430 million5. IRR CalculationWe use the standard IRR formula:Plug in the numbers:👉 In finance interviews, it’s not just about knowing the formulas – you should also be able to run quick calculations in your head with confidence. Check out our Mental Math Tool and sharpen your calculation skills!