What Is the Earnings Multiplier?
The earnings multiplier frames a company's current stock price in terms of the company's earnings per share (EPS) of stock. It presents the stock's market value as a function of the company's earnings and is computed as (price per share/earnings per share). It is also known as the price-to-earnings (P/E) ratio. It can be used as a simplified valuation tool for comparing relative costliness of the stocks of similar companies, and for judging current stock prices against their historical prices on an earnings relative basis.
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 stock. This is an important relationship because the price of a stock is 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 could potentially indicate that it is not a good time to buy the stock because the stock is expensive. In addition, comparing earnings multipliers across similar companies can help rate how expensive the companies' stock prices are relative to each other.
Example of the Earnings Multiplier
For example, if company ABC has a current stock price of $50 per share and earnings per share (EPS) of $5, 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 $50 and EPS of $7, the multiplier would have been 7.14 years.
The current price would be more expensive relative to current earnings than the price 10 years ago because the price 10 years ago was only trading at 7.14 times earnings instead of 10 times earnings like it is currently. Comparing company ABC's earnings multiplier to other similar companies can also provide a simplified gauge for 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 and can be said to be relatively more expensive than the stock of company ABC, which has a multiplier of only 10 years.