Earnings Multiplier
A valuation method used to assess a company's share price compared to other businesses in a comparable industry.
The earnings multiplier, known as the price-to-earnings ratio (PE ratio), is a valuation method used to assess a company's share price compared to other businesses in a comparable industry.
The multiplier is an effective way to judge whether a company's stock is under or overvalued. In addition, it can be a good measure to assess how expensive a stock's current price is compared to the company's earnings per share of that stock.
When a stock's price is historically high concerning its earnings, it can be a sign that there are better times to invest in this share since it is too expensive.
Likewise, the multiplier can also be used to compare how high particular stock prices are compared to one another. It can be used to evaluate the financial stability of companies as well.
What is the formula for the Price-to-earnings ratio?
The PE ratio can be computed by dividing the firm's share price by its earnings per share. However, it can also be calculated on a whole-firm basis where the equity value of the firm (also known as the market capitalization/market cap) is divided by its after-tax earnings.
PE ratio = Share Price/ Earnings per share (EPS) or PE ratio = Equity value or Market cap/ After-tax earnings
For example, The stock price of company X is trading at $10 per share, and its earnings per share are $2. Therefore, the multiplier will be 10/2, which is 5.
It suggests that an investor will spend $5 for every dollar the company makes. The investor will pay five times the current worth of the company.
- The share price or price per share is the price at which the company's shares are traded on the exchange market.
- The Earnings per share (EPS) is calculated by dividing a company's net profit by the total number of outstanding common shares.
- The total worth of all a company's stock shares is referred to as market capitalization, also known as the market cap or equity value. It can be computed by multiplying the price of a stock by the total number of outstanding shares.
Understanding PE ratios
Within the FCFE (free cash flow to equity) framework, a firm with no growth in earnings can be written as:
P0 = FCFE1/ Ke = e1/ ke
Where P0 is the equity value at time 0 (in other words, the present value), e1 is earnings at time 1, and ke is the cost of equity.
By rearranging the terms, we get
P0 / e1 = 1/ ke
This implies that the PE ratio depends on the time value of money and the risks of the firm's future earnings.
When we assume that the firm has opportunities to grow its earnings, then:
P0 = e1/ ke + G
Where G refers to the firm's growth opportunities.
With rearrangement, the value of a firm with growth becomes:
P0 / e1= 1/ ke + G/ e1
Value of a firm with growth = Value of a firm with no growth + weight of the firm's growth opportunities
This implies that the PE ratio now depends on three factors which is
- the time value of money
- risks to the firm's future earnings
- growth of the firm's future earnings
For example, consider a company that currently earns $1 million annually. If the company
now has a PE of 15 and an annual cost of equity of 10%, thus we
can break down the PE into:
A part is attributable to current earnings
1/ ke = 1/ 0.1 = 10
and another part is attributable to future growth, which is
G/ e1 = P0/ e1 - 1/ ke = 15 - 10 = 5
which implies that 5/15 of the current value represents future growth.
There are several types of earnings multipliers. The three main ones are the historical PE ratio, trailing PE ratio, and forward PE ratio.
The historic earnings multiplier originates from the annual reported earnings of the most recent financial year.
What are the Trailing and Forward Multipliers?
The trailing earnings multiplier uses earnings calculations over the past 12-month period and is one of the most frequently used price-to-earnings indicators.
The last is the forward earnings multiplier which uses estimated earnings in its calculations for the next 12-month period.
One of the most common questions asked is: What leads to high and low PE ratios?
Several factors lead to high and low PE ratios. The four main ones are
- growth
- risk
- risk-free rate (Rf), or
- a combination of all 3.
A high PE ratio is usually caused by high growth, low risk, low risk-free rate, or a combination. Conversely, a low PE ratio is generally caused by low growth, high risk, high risk-free rate, or variety.
A company's share price rises due to high interest from investors, which raises the multiplier, implying that the stock is overvalued. Likewise, when the multiplier is low, it is a sign that the stock is undervalued.
This explains how companies that exhibit high growth and low risk are likely to have high multipliers, while companies that show lower growth and increased risk are likely to have lower multipliers.
Equity valuation using earnings multiple
Earnings multipliers can be used to estimate the equity value of a company. The equity value can be calculated by multiplying the expected future earnings with the price-earnings multiple.
P0 = e x PE
Where P0 is the equity value at time 0, e is earnings, and PE is the earnings multiple.
For example: Suppose a company projects that future earnings will be $10 million annually. We estimate from the market that the PE multiple will be 10, based on competitor firms.
Therefore, the estimate of the equity value will be $10 mil x 10 = $100mil.
Valuing equity in a company requires the estimate of two things, which are:
- The expected future earnings
Estimating future earnings usually starts with the most recent trailing twelve months (TTM) earnings. Accordingly, many analysts and professionals carefully examine these earnings (as well as the earnings over the previous several years) to ascertain whether they represent a reliable proxy for projecting the firm's future earnings.
The earnings need to be adjusted with several adjustments, including one-off items and income from surplus assets or liabilities. The post-adjustments earnings are typically referred to as normalized earnings.
- The PE multiple
Estimating PE multiples requires observing the PE ratios of competitor firms, commonly known as stock earnings multiples. There are also PE multiples at which competitor firms have been bought and sold, known as transaction multiples.
Competitor firms are also renowned as comparable firms. On the other hand, a set of competitor firms is known as a peer group.
Selection of competitor firms starts with choosing firms with similar or the same operations as the valued firm. For example, Starbucks and Coffee Bean or Apple and Samsung. Typically these firms operate in the same industry.
Comparable firms usually have similar cash flows, growth, and risk compared to valued firms. Once you have your list of comparable companies, you should alter the earnings to eliminate the effect of one-time and non-operating items.
After adjustments of earnings, using the current stock prices (stock market multiples) or transaction prices (transaction multiples) will provide a set of PE ratios.
What are the limitations?
Even though the earnings multiplier can be a valuable tool in valuing companies, certain drawbacks must be considered.
The main limitations are -
- It might be challenging to use as it differs significantly across different industries.
- Earnings calculated in calculating the P/E ratio might need to be more accurate due to the various accounting techniques used (earnings management). Many companies may report positive earnings but, in reality, face negative cash flow.
- Calculating a company's P/E might be difficult for unprofitable businesses with no earnings or negative earnings per share.
- Due to the various ways that organizations generate revenue and the different time frames over which they do so, valuations and growth rates of corporations can frequently range drastically between industries affecting the PE ratio.
- In terms of valuation, no single metric, which includes the PE ratio, can determine if a stock is a wise investment.
Conclusion
The Earnings Multiplier (EM) is a valuation tool that can estimate a company's share price or equity. It is known by many names, such as the price-to-earnings ratio, price-to-earnings multiple, or price multiplier.
It can be calculated in two ways: the first is by dividing the company's share price by its earnings per share, and the second is by dividing the company's equity value by its after-tax profits.
There are three central EMs. The first is the trailing earnings multiplier which uses earnings over the past 12-month period; the forward earnings multiplier, which uses earnings over the next 12-month period and the historic earnings multiplier, which uses annual reported earnings of recent FY.
Four main factors lead to high and low PE ratios: growth, risk, risk-free rate (rf), and a combination. A high PE ratio comes from a high gain, low risk, low risk-free rate or a variety, while a low PE ratio comes from low growth, high risk, and high risk-free rate or a combination.
The EM can value equity by multiplying the expected future earnings with the price-earnings multiple.
To conclude, it can be a valuable tool in making investment decisions using common market indicators like share price and PE ratio. Moreover, it is relatively easy to use, although the selection of comparative peers might be subjectively difficult.
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