Earnings Multiplier Formula & Example
Earnings Multiplier Definition
The earnings multiplier is a variation of the price to earnings ratio that adjusts the current p/e to account for current interest rates. This is done in order to discount future earnings against monies that could be invested at the current interest rate over the same period of time. This is much like the discounted cash flow where future earnings are adjusted in order to get the current market price. This allows an investor to determine the present price to earnings for each share against projected future earnings.
Earnings Multiplier Formula
Below are the values associated with the earnings multiplier:
- k - level of risk associated with the company
- g - future growth earnings
- EPS - expected earnings per share
- P - (EPS/(k-g))
Importance of Earnings Multiplier
The earnings multiplier is a critical factor in assessing a business because it factors in the future growth potential of the company. Investing is about knowing where to put your money with the hopes of making a return in the future. While there is no universal earnings multiplier, it is best to look at the earnings multiplier across a specific industry. With this information in hand a potential investor can then use this as another input when determining a company's true value. However, a investor must remember that a market of buyers and sellers may not believe the company is worth its book value. This can best be seen during the credit crisis of 2008. As the Dow was making new highs, there were a few analysts that were saying the major banks were in serious trouble because the risk associated with the credit default swaps was too high. These analysts were shouting that it was impossible to estimate future earnings because credit default swaps were not detailed on the books. All the while large rating agencies were ranking these credit default swaps highly and classified them as "healthy risk". So, both the valuation of the companies and the stock price stayed inflated. But the few analysts who said the risks were too high were eventually proven right when these stocks began to plummet during the 2008 sell off.