Earnings Multiplier

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Earnings Multiplier
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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).

Examples of Earnings Multiplier

  • Price/Earnings (P/E) Ratio: The most common earnings multiplier is the price-to-earnings (P/E) ratio. This ratio measures the market value of a company's stock against its reported earnings per share (EPS). A higher P/E ratio indicates that the stock is more expensive relative to its recent earnings.
  • Price/Earnings to Growth (PEG) Ratio: The price-earnings to growth (PEG) ratio is an earnings multiplier that takes into account the company's projected growth rate. It is calculated by dividing the P/E ratio by the company's expected earnings growth rate. A higher PEG ratio indicates that the stock is overvalued relative to its expected earnings growth.
  • Price/Sales (P/S) Ratio: The price-to-sales (P/S) ratio measures the market value of a company's stock against its annual sales revenue. A higher P/S ratio indicates that the stock is more expensive relative to its recent sales performance.
  • Price/Book (P/B) Ratio: The price-to-book (P/B) ratio measures the market value of a company's stock against its book value (assets minus liabilities). A higher P/B ratio indicates that the stock is more expensive relative to its book value.

Advantages of Earnings Multiplier

Earnings multipliers are a valuable tool for investors and business owners alike to measure the relative success and potential of a specific industry in a region. They provide a quantitative measure of the economic activity of a region by taking into account the relative earnings paid by the industry, both directly and indirectly. Below are some of the advantages of using earnings multipliers:

  • Earning multipliers allow investors to easily compare the relative costliness of companies stocks and to judge current stock prices on a comparative earnings basis against their historical prices.
  • They provide a valuable insight into the economic activity of a region and can help investors identify which industries are currently performing well and can provide valuable information to business owners looking to invest in a specific industry.
  • They are also a useful tool for comparing the performance of different industries in different regions.
  • In addition, earnings multipliers can be used to inform decision-making, such as the decision of whether to invest in a specific stock, or to decide which industry to focus on in a certain region.
  • Finally, earnings multipliers can be used to identify potential investments and opportunities in emerging industries.

Limitations of Earnings Multiplier

Earnings multipliers can be a useful tool for evaluating stocks, but it is important to be aware of their limitations. These include:

  • Earnings multipliers are based on past performance and may not accurately reflect future earnings. As a result, they can be unreliable when estimating the future performance of a company.
  • Earnings multipliers do not take into account differences in the size and complexity of different companies, which can make them less useful when comparing companies of different sizes.
  • Earnings multipliers do not account for non-financial factors such as competitor behaviour, customer loyalty, or industry trends, which can affect the performance of a company.
  • Earnings multipliers are based on the historical performance of a company, which may not reflect current economic conditions or the future outlook for the company.
  • Earnings multipliers may not accurately reflect the value of a company’s intangible assets, such as patents and trademarks.
  • Earnings multipliers may not accurately reflect the true value of a company’s stock, as they do not take into account any potential changes in the company’s future prospects.

Other approaches related to Earnings Multiplier

  • Comparative Performance Analysis: This approach assesses a company's performance relative to its peers in the same industry. It uses financial ratios such as return on assets, return on equity, and price to earnings ratio to compare the performance of the company to its competitors.
  • Technical Analysis: This approach uses charts and technical indicators to forecast future stock prices. It looks at the historical price and volume data of a security and attempts to identify trends in order to predict future prices.
  • Fundamental Analysis: This approach looks at a company's financial health, its competitive position in the industry, and its growth potential in order to determine its intrinsic value.

In summary, Earnings Multiplier is 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. Other approaches related to Earnings Multiplier are Comparative Performance Analysis, Technical Analysis and Fundamental Analysis.

References

Author: Elżbieta Woyke

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