What is the Equity Multiplier?
The equity multiplier is a financial leverage ratio that measures the portion of company’s assets that are financed by stockholder's equity. It is calculated by dividing a company's total asset value by total net equity.
Equity multiplier = Total assets / Total stockholder's equity
Understanding the Equity Multiplier
Investment in assets is key to running a successful business. Companies often finance these assets through the the process of issuing equity and debt. The equity multiplier reveals how much of the total assets of a company are made up of debt and equity. Essentially, this ratio is a risk indicator in that it shows how leveraged the company is to investors and creditors.
A higher equity multiplier number indicates that the debt portion of total assets is increasing which translates to more financial leverage for the company. Companies with a higher debt burden will have higher debt servicing costs which means that they will have to generate more cash flows to sustain optimal operating conditions. The equity multiplier is therefore a variation of the debt ratio.
Debt Ratio = Total Debt ÷ Total Assets = 1 - (1 ÷ Equity Multiplier)
A low equity multiplier implies that the company is loathe to take on debt, which is usually seen as a positive as their debt servicing costs are lower, but it could also mean that the company is unable to entice lenders to loan them money, which would be a negative.
Equity multiplier gives investors a snapshot of a company's capital structure which can aid them in their investment decisions. It can be used to compare multiple companies in the same period or the same company in different periods. The basic way to interpret this number is:
- High equity multiplier could indicate that the company may be overly dependent on debt for its financing which would make it a potentially risky investment. The upside is that, due to its high financial leverage, the growth prospects might be enticing.
- Low equity multiplier reveals a company that is mostly funded by stockholders and that the debt financing is low making it a fairly conservative investment. The flip side is that its growth prospects might not be too high given its low financial leverage.
- The ideal scenario would be to find a company that has found a way to balance both equity and debt so that it can outperform its peers. Market consensus, though it can vary by sectors and industries, is that an equity multiplier of 2:1 is an optimal balance of debt and equity for a company to finance its assets.
- The equity multiplier is a financial leverage ratio that measures the portion of company’s assets that are financed by stockholder's equity.
- The equity multiplier is a risk indicator in that it shows how leveraged the company is to investors and creditors.
- The equity multiplier is also an important factor in DuPont factor analysis, which is a method of financial assessment
Calculation of the equity multiplier is relatively simple and straightforward. Consider the balance sheet of Apple Inc.(AAPL) as of the end of fiscal year 2017. The company's total assets were $375 billion, and the book value of shareholder equity was $134 billion. The company's equity multiplier was therefore 2.79 (375 / 134), which can be compared with its equity multiplier for 2016, which was 2.34.
Verizon Communications Inc. (VZ) operates with a very different business model that includes more financial leverage. The company's total assets were $257 billion as of end of fiscal year 2017, with $43 billion of shareholder equity. The equity multiplier was 5.98 (257 / 43), based on these values.
Verizon's much lower proportionate shareholder equity value indicates that the business relies more heavily on financing from debt and other interest-bearing liabilities. The company's telecommunications business model is more reminiscent of utilities firms, which have stable, predictable cash flows and typically carry high debt levels.
On the other hand, Apple is more susceptible to changing economic conditions or evolving industry standards than utilities or large traditional telecommunications firms. As a result, Apple has less financial leverage. Differences in business models mean that higher financial leverage does not necessarily indicate superior financial health.
The equity multiplier is also an important factor in DuPont factor analysis, which is a method of financial assessment devised by the DuPont Corp. for the purpose of internal review. The DuPont model breaks return on equity (ROE) into its constituent pieces, which are popular financial ratios and metrics.
Net profit margin, asset turnover and the equity multiplier are combined to calculate ROE, which allows analysts to consider the relative impact of each separately. If ROE changes over time or diverges from normal levels for the peer group, DuPont analysis indicates how much of this is attributable to financial leverage. If the equity multiplier fluctuates, it can significantly affect ROE. Higher financial leverage drives ROE upward, all other factors remaining equal.