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What Is the Earnings Multiplier?
The earnings multiplier is a financial valuation metric that frames a company’s current stock price in terms of the company’s earnings per share (EPS) of stock.
The earnings multiplier is computed as price per share divided by earnings per share. It’s also known as the price-to-earnings (P/E) ratio.
The earnings multiplier can help investors compare current stock prices to historical prices based on earnings. It can also be used as a simplified valuation tool to compare the relative costliness of the stocks of similar companies.
Read on to learn about examples and practical applications of the earnings multiplier.
Key Takeaways
- The earnings multiplier compares a company’s stock price to its earnings per share (EPS).
- It is calculated by dividing the stock price by EPS, also known as the price-to-earnings (P/E) ratio.
- This metric helps investors assess if a stock is priced fairly relative to its earnings.
- Comparing earnings multipliers among similar companies can highlight stock price costliness.
- The earnings multiplier should be used for relative valuation, not absolute valuation analysis.
Why Earnings Multipliers Matter in Stock Valuation
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 (EPS) 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 another.
Practical Example: Calculating 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 EPS of $5. Under this set of circumstances, 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.
You can also say, “Company ABC is trading at 10 times earnings,” since $50 is 10 times the $5 EPS. Ten years ago, if Company ABC’s market price was $50 and EPS was $7, the multiplier would be 7.14 years.
Important
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 companies helps assess how expensive a stock is relative to 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.
The Bottom Line
The earnings multiplier, also known as the price-to-earnings (P/E) ratio, compares a company’s current stock price to the company’s earnings per share (EPS). This financial metric aids investors in stock valuation.
The earnings multiplier is also important for investors in determining a stock’s relative expense and comparing similar companies or historical stock performance.
The example above of Company ABC explains how the earnings multiplier is calculated (price per share divided by earnings per share) and is used to compare stock prices and EPS over time.
Remember, the earnings multiplier is a relative valuation tool and should not be used for absolute valuation decisions on stocks.
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