What Is the Earnings Multiplier?
Let me explain the earnings multiplier to you directly—it's a financial metric that positions a company's current stock price against its earnings per share (EPS), calculated simply as price per share divided by earnings per share. You might know it as the price-to-earnings (P/E) ratio, and I use it as a basic valuation tool to compare how costly stocks are among similar companies. It also lets you evaluate current stock prices relative to their historical levels based on earnings.
Key Takeaways
- The earnings multiplier positions a company's current stock price in terms of its earnings per share (EPS).
- You compute this metric as price per share divided by earnings per share.
- The earnings multiplier helps you determine how expensive a stock's current price is relative to the company's earnings per share.
Understanding Earnings Multiplier
You can rely on the earnings multiplier as a practical tool to figure out how expensive a stock's current price is compared to the company's earnings per share. This relationship matters because a stock's price should theoretically reflect the expected future value of the company and the cash flows from owning that stock. If a stock's price is historically high relative to earnings, it might signal that now isn't the best time to buy since it's overpriced. Additionally, when you compare earnings multipliers between similar companies, you get a clear view of how their stock prices stack up against each other.
Example of the Earnings Multiplier
Take this example with a fictional company ABC to see the earnings multiplier in action. Suppose the company has a current stock price of $50 per share and earnings per share (EPS) of $5. In this case, the earnings multiplier comes out to $50 divided by $5, which equals 10 years. That means it would take 10 years to recover the $50 stock price based on the current EPS.
You could also say that Company ABC is trading at 10 times earnings, since the $50 price is 10 times the $5 EPS. Now, if 10 years ago the company had a market price of $50 and EPS of $7, the multiplier would have been $50 divided by $7, or about 7.14 years.
Here's an important point I need to stress: the earnings multiplier should only be used for relative valuation of investments and not for absolute stock valuation.
The current price is more expensive relative to current earnings than it was 10 years ago, because back then the stock traded at 7.14 times earnings compared to the current 10 times. You can also compare Company ABC's multiplier to similar companies for a quick assessment. If Company XYZ has an EPS of $5 but a stock price of $65, its multiplier is 13 years, making it relatively more expensive than ABC's 10-year multiplier.
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