What is an Earnings Multiple?
The earnings multiple is a common stock market metric that measures how much the market values a stock. Also known as the price-to-earnings, or P/E, ratio, this ratio is reached by taking the price of the stock and dividing it by the earnings per share of the underlying company over a specific time period. Investors can calculate the earnings multiple based on past earnings reports or estimate the ratio based on future projections. If the earnings reports are accurate, this ratio can be especially useful when measuring stocks in similar industry sectors against each other.
Accurate stock valuation is the goal of investors everywhere, as they attempt to determine whether stocks are either overpriced or undervalued to get the most out of their investment dollars. At times, the price of a certain stock may not reflect its actual value, but instead may be based on its potential in the future. On other occasions, performance of a company may not quite jibe with the way the market values it. The earnings multiple is a way for investors to use price and earnings levels to calculate the market's view of a particular stock.
As an example of an earnings multiple, imagine that a certain stock has a current price of $60 US Dollars (USD) per share. The underlying company behind that stock releases an earnings report which shows that earnings for the past year were equivalent to $2 USD per share. To calculate the multiple, $60 USD is divided by $2 USD, yielding a total of $30 USD. In essence, that means that an investor is paying $30 USD for every $1 USD of earnings.
Many investors attempt to estimate the earnings multiple by using future earnings projections from a company as a measuring stick. Since these projections can't possibly be verified with any certainty, this is a bit of a risky ploy, but it can be savvy if the projections are close to accurate. The danger in trusting P/E ratios is that they ultimately depend on the veracity of earnings reports, which can be manipulated by a company's accounting tricks.
In general, a company that has a high earnings multiple is being regarded by the market much higher than its earnings might indicate. This can be because the company has a proven track record or that investors are betting on its potential. A company with a low ratio might be flying under the radar of the market. Establishing a P/E benchmark for a specific industry is a good way to measure one stock against others like it.
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