What is the Earnings Multiplier?
The earnings multiplier, or the price-to-earnings ratio, is a method used to compare a company’s current share price to its earnings per share (EPS).
It is used as a valuation tool to compare the share price of a company with that of similar companies. The earnings multiplier also shows how much an investor will be paying for one dollar earned by the company.
The earnings multiplier can be used to assess a company’s financial health. The price-to-earnings ratio of several companies can be compared while making investment decisions.
The earnings multiplier calculates the return an investor will get against the invested amount. Furthermore, a company’s share price depends on the future value of the company issuing the shares. It also shows the performance of a company compared to its industry counterparts.
- The earnings multiplier compares the current share price of a company with its per-share earnings.
- Investors can use the earnings multiplier to determine how expensive the company’s share price is relative to its earnings per share.
- Investors can use the earnings multiplier for the valuation of a firm’s stocks and compare it with industry counterparts or market indexes such as the NASDAQ Composite.
Formula of the Earnings Multiplier
The earnings multiplier can be calculated using the following formula:
Earnings Multiplier or P/E Ratio = Price Per Share/ Earnings Per Share
- Price per share is the prevalent market price of a company’s stock. It is the price at which the company’s shares are trading in the exchange market.
- Earnings per share is the net profits earned by the company per share outstanding in the stock market.
For example, the share price of a company is now trading at $100 per share, and its per-share earnings is $10. The earnings multiplier will be 10 ($100/$10).
It implies that for one dollar earned by the company, an investor will pay $10. The investor will be paying 10 times the company’s present value. He will need to compare the value with industry counterparts to determine whether the price-to-earnings ratio is high or low.
If the company’s earnings multiplier is higher than that of the industry average, we say that the share price of the company is high.
Reasons for High and Low Earnings Multipliers
The earnings multiplier can be high or low due to the following reasons:
- When a greater number of investors show interest in the shares of a company, the price of the shares increases, which results in a higher earnings multiplier. In the case where the share price is undervalued, the earnings multiplier is low.
- Companies that are exhibiting growth tend to report a high earnings multiplier. Similarly, companies with low or negative growth show a low earnings multiplier.
Types of Earnings Multipliers
The following are the two most common types of earnings multipliers:
Forward Earnings Multiplier
Also called the estimated earnings multiplier, it is used to compare the present earnings with future earnings. It provides a clear picture of the company’s earnings in the future – assuming no changes or adjustments.
However, companies may either overestimate or underestimate their earnings to meet the expected earnings multiplier. Market analysts also come up with estimates for earnings multipliers, which may be very different from the company’s estimates, resulting in confusion.
Trailing Earnings Multiplier
It depends on the company’s past performance, considering a 12-month period for calculations. It is the most commonly used price-to-earnings indicator, as it is based on facts assuming that the reported earnings are accurate.
Investors prefer the tradings earnings multiplier, as they often lack faith in estimates presented by others. However, the past performance of a company does not always reflect its future performance.
If the forward earnings multiplier is lower than the trailing earnings multiplier, it implies that the analysts are predicting an increase in the company’s earnings. Conversely, if the forward earnings multiplier is higher, the analysts are predicting a decrease in the company’s earnings.
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