What is Earnings Multiplier?
Earnings Multiplier, known as the Price-to-Earnings Ratio, is a method to compare the current market price of a share to earnings per share of the company. In simple words, it is a measure of valuation in order to determine what you are willing to pay for every single amount of dollar a company is able to earn.
If you want to invest in the shares of any company, it is very important to know the right stock price of that company. It should not be overvalued or undervalued. You need to compare the amount that is invested and the return you will get from it. This is calculated through a Price Earnings ratio.
Price-Earnings Ratio has to be compared with the peers or Industry Average.
Earnings Multiplier Formula
Price-to-Earnings Ratio is represented as follows –
- Price per Share is the Current Market Price of a share of the company. In simple words, it is the price at which the share of a company is currently trading in the market.
- Earnings per Share is calculated as the net profits of a company divided by a total number of the shares of a company.
Examples of Earnings Multiplier
Let’s understand this concept with the help of examples.
Example #1
Company A is currently trading at $150 per share and earnings per share is calculated as $10. Let’s calculate the P/E ratio here.
Solution
Calculation of P/E Ratio of Company A
- = 150 / 10
- P/E Ratio = 15
Calculation of P/E Ratio of Company B
- =300/15
- P/E Ratio = 20
P/E ratio of 15 indicates that an investor is willing to pay 15 times the current value of the company.
In order to determine whether a company’s P/E ratio is high or low, we need to compare it with its industry peers.
Average Industry P/E is 18. Here, we can say that company B’s share is expensive as compare to industry standards.
Example #2 – Low P/E, Low Growth
As per the below table, the earning per share of the company is increasing at a rate of 10% every year and the price of the share is also increasing at the same rate. P/E ratio remains the same every year.
Example #3 – High P/E, High Growth
Here, the company is growing at a 100% rate every year. The earnings per share are getting double in year 2 and 3. Price of the share is also increasing at a high rate. Hence, the P/E ratio is also maintained high.
Example #4 – Low P/E, Negative Growth
Below table shows the negative growth of the company over the years 2 & 3. Since the earning per share is declining, the price of the share is also reducing. P/E ratio is also reducing.
Example #5 – Moderate P/E, Steady Growth
Here, the earnings per share and market price of shares of the company are increasing at a very high rate but the price to earnings ratio is not increasing at the same rate. This happens mostly in the case of cyclical companies.
Refer the excel sheet given above for detail calculation.
Reasons for High P/E and Low P/E
Here are the few reasons for low P/E –
- Stock is undervalued: It is possible that the stock price is valued at a lower rate.
- Low growth or negative growth: Companies’ P/E ratio depends upon the growth of the company.
- Future prospects: If future prospects of the company are not great, it will result in low P/E.
Here are the few reasons for High P/E –
- Stock is overvalued: More investors are interested in the stock of the company which will result in a higher price and higher P/E ratio.
- High Growth: Companies’ P/E ratio depends upon the growth of the company.
- Future prospects: If future prospects of the company are expected to be great, it will result in high P/E.
Importance
- Earnings multiplier or P/E ratio is an important tool to know about the company’s financial health.
- Investors can compare the P/E ratio of various companies and decide where the investment is to be made.
- P/E ratio also indicates how the company is performing as compared to the industry peers.
Conclusion
Hence, the price to earnings ratio is an important tool to analyze the company’s stock. P/E ratio compares the company’s stock price to its earnings per share. Higher P/E ratio could imply higher growth prospects for the company or stock is overvalued. On the other hand, a lower P/E ratio indicates low growth or undervaluation of stock.
Recommended Articles
This has been a guide to Earnings Multiplier. Here we discuss the formula for calculation of earnings multiplier along with its examples and reasons for high and low P/E. You may also have a look at the following articles –
