Earnings Multiplier

Earnings Multiplier
See also

Earnings multipliers for a given industry in a region indicate the earnings paid by the given industry, both directly and indirectly, to households employed in regional industries to deliver a dollar of output to final demand (U.S. Department of Commerce, 1986, p.6). They can be used as a simple valuation tool to compare the relative costliness of different companies' stocks and to judge current stock prices on a comparative earnings basis against their historical prices.  

"RIMS II issues a series of multipliers for various sectors of a specified region, generated via the region's location quotients. Some examples are as follows:

  • Output multiplier - gives the change in the production output of a sector resulting from a 1 dollar change in the demand for another sector's output.
  • Earning multiplier - gives the change in the workplace earnings of a sector resulting from a 1 dollar change in the demand for another sector's output.
  • Employment multiplier - gives the change in the number of workers of a sector resulting from a 1 dollar change in the demand for another sector's output" (Y. Y. Haimes, 2018, p. 321).

Earnings Multiplier Model

Most investors tend to use an earnings multiplier model to estimate the value of common stock. The rationale for this approach recalls the fundamental concept that the value of any investment is the present value of future returns. In the case of common stocks, the returns that investors are entitled to receive are the net earnings of the firm. Thus, one way in which investors can estimate value is by determining how many dollars they are willing to pay for a dollar of expected earnings (typically represented by the estimated earnings over the next 12-month period or an estimate of "normalized earnings"). For example, if investors are willing to pay 10 times expected or "normal" earnings, they would value a stock they expect to earn 2 dollars a share during the following year at 20 dollars. The predominant earnings multiplier, also known as the price/earnings ratio (P/E) can be estimated as follows:

Earnings Multiplier = Price/Earnings Ratio = Current Market Price/Expected 12-Month Earnings

This estimate of the earnings multiplier (P/E ratio) shows the prevalence of shareholders' attitude towards the value of a stock. Investors must decide whether they agree with the prevailing P/E ratio (that is, is the earnings multiplier too high or too low) based upon how it compares to the P/E ratio for the aggregate market, for the firm's industry, and for similar firms and stocks (F. K. Reilly, K. C. Brown, 2011, p. 347-348).

References

Author: Elżbieta Woyke