What Is Multiple Compression?
Multiple compression is an effect that occurs when a company's earnings increase, but its stock price does not move in response. Following this trend, if the company posts flat earnings, the stock price could fall or in some cases, the stock price drops faster than the earnings. The result is that its price multiples, such as its P/E ratio, are reduced since the denominator increases while the numerator remains the same, even though nothing may be fundamentally wrong with the company.
The compression of a company's multiple can be interpreted as a company's valuation being called into question or a change in investor expectations.
- Multiple compression occurs when a company's financial multiple decreases, often representing a change in investor expectations.
- Multiples like the P/E ratio are used to analyze a company's relative valuation in the market.
- Multiple compression can occur if share prices fall while earnings stay flat or if share prices remain the same while earnings increase.
Understanding Multiple Compression
A price multiple is any ratio that uses the share price of a company in conjunction with some specific per-share financial metric for a snapshot on relative valuation. The share price is then divided by a chosen per-share metric to form a ratio. Price multiples enable investors to evaluate the market value of a company's stock in relation to a fundamental metric, such as earnings, cash flow, or book value (P/B). Compression occurs when these multiples shrink.
Multiples are based on several factors, but most importantly on the future expectations of a company. If a company trades at say, a P/E multiple of 50, this means investors are paying $50 in equity for each $1 of earnings. Generally, an investor would only pay such a high multiple on the expectation that the company will grow significantly faster than its competitors or the stock market in general.
When the company's growth rates start to slow, investors might start to doubt its growth prospects, and thus not pay as expensive a premium as they once did. Expectations about future prospects can be dashed if a company misses earnings or gives negative forward guidance.
Example of Multiple Compression
In the case above, our hypothetical company begins with a P/E of 50. The company might experience multiple compression if it releases earnings that are double the previous earnings per share (EPS). Meanwhile, the stock price remains the same. The P/E will thus be reduced to 25, even though earnings have improved. With the same dollar of earnings, this would mean that the stock's relative value has been cut in half (25/50 = 1/2).
Alternatively, assume the company releases earnings that are exactly the same as the prior earnings, but the stock price falls by 50%. The result would be the same in terms of the P/E. This demonstrates how the stock price could go down when earnings stay the same.