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). It’s computed simply as price per share divided by earnings per share. Also known as the price-to-earnings (P/E) ratio, the earnings multiplier serves as a popular valuation tool for comparing the relative costliness of stocks from similar companies. Investors can leverage this metric not only to judge current stock prices against their historical prices on an earnings-relative basis but also to make more informed investment decisions.
Key Takeaways
- The earnings multiplier measures a company’s current stock price relative to its earnings per share (EPS).
- This key metric is calculated as price per share divided by earnings per share.
- The earnings multiplier can help investors determine the relative expense of a stock.
Understanding the Earnings Multiplier
The earnings multiplier offers a quick snapshot of how expensive a stock is based on the company’s earnings per share. Theoretically, the price of a stock reflects the anticipated future value of the issuing company and cash flows resulting from ownership. If a stock’s price is historically expensive relative to its earnings, it might not be the optimal time to buy, as the stock could be overvalued. Additionally, comparing earnings multipliers among similar companies helps investors understand the relative expense of different stocks.
Real-Life Example of the Earnings Multiplier
Consider a fictitious corporation, ABC Inc. This company has a current stock price of $50 per share, with EPS standing at $5. Under these conditions, the earnings multiplier would be:
$50 per share / $5 EPS = 10
This outcome means that it would take 10 years to recover the $50 stock price given the current EPS. Investors might say, “ABC Inc. is trading at 10 times earnings,” indicating the stock price is 10x the $5 EPS. If 10 years ago ABC had a market price of $50 and an EPS of $7, the earnings multiplier would have been only 7.14. Comparing these figures shows the stock is relatively more expensive now.
By evaluating ABC’s earnings multiplier against rival companies, investors can determine which stock is more costly relative to earnings. For example, if company XYZ also has an EPS of $5 but trades at $65 per share, its earnings multiplier would be 13. Therefore, XYZ might be deemed more expensive compared to ABC, which has an earnings multiplier of 10.
The earnings multiplier is ideally used to compare investments on a relative basis, rather than to gauge an absolute valuation of a stock. Usage should therefore be complemented with other analytical tools for a comprehensive investment decision.
Related Terms: P/E Ratio, Earnings Per Share, Stock Price, Valuation, Future Value.
