What Is the Earnings Multiplier?
The earnings multiplier is a financial metric that frames a company's current stock price in terms of the company's earnings per share(EPS) of stock, that's simply computed as price per share/earnings per share. Also known as the price-to-earnings (P/E) ratio, the earnings multiplier can be used as a simplified valuation tool with which to compare therelative costliness of the stocks of similar companies. It can likewise help investors judge current stock prices against their historical prices on an earnings-relative basis.
Key Takeaways
- The earnings multiplier frames a company's current stock price in terms of the company's earnings per share (EPS) of stock.
- This metric is computed as price per share/earnings per share.
- The earnings multiplier can help investors determine how expensive the current price of a stock is relative to the company's earnings per share of that stock.
Understanding Earnings Multiplier
The earnings multiplier can be a useful tool for determining how expensive the current price of a stock is relative to the company's earnings per share of that stock. This is an important relationship because the price of a stock is theoretically supposed to be a function of the anticipated future value of the issuing company and future cash flows resulting from ownership of that stock. If the price of a stock is historically expensive relative to the company's earnings, it may indicate that it's not an optimal time to purchase this equity because it's overly expensive. Furthermore, comparing earnings multipliers across similar companies can help illustrate how expensive various companies' stock prices are relative to one other.
Example of the Earnings Multiplier
As an example of a practical application of the earnings multiplier, consider fictitious company ABC. Let's assume this corporation has a current stock price of $50 per share and earnings per share (EPS) of $5. Under this set of circ*mstances, the earnings multiplier would be 50 dollars/5 dollars per year = 10 years. This means it would take 10 years to make back the stock price of $50 given the current EPS.
The multiplier can also be verbally expressed by saying, "Company ABC is trading at 10 times earnings," because the current price of $50 is 10x the $5 EPS. If 10 years ago, company ABC had a market price of $50and EPS of $7, the multiplier would have been7.14 years.
The earnings multiplier should only be used to value investments on a relative basis and shouldn't be used to gauge an absolute valuation of a stock.
The current price would be more expensive relative to current earnings than the price 10 years ago because, at that time, the stock was only trading at 7.14 times earnings instead of 10 times earnings it trades at currently.
Comparing company ABC's earnings multiplier to other similar companies can also provide a simple gaugefor judging how expensive a stock is relative to its earnings. If company XYZ also has an EPS of $5, but its current stock price is $65, it has an earnings multiplier of 13 years. Consequently, this stock may be deemed to be relatively more expensive than the stock of company ABC, which has a multiplier of only 10 years.
