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The earnings multiple of a stock, also called the price/earnings (P/E) ratio, is the share price divided by the earnings per share. The earnings multiple is often based on the prior twelve months of earnings data. However, the earnings multiple can also be based on the estimated future earnings. A $40 stock with $2 in annual earnings, for example, has an earnings multiple of 20. Unprofitable companies have no earnings or negative earnings cannot be valued based on an earnings multiple.
The higher the earnings multiple, the more investors are willing to pay for future growth. Using the earnings multiple and estimates of future earnings, investors can project a future value for a stock.
When large numbers of stocks see their earnings multiples decline, the market is said to be undergoing multiple compression. Conversely, when the average earnings multiple increases, the market is undergoing multiple expansion. Changes in the earnings multiple of an individual stock are often evaluated in the context of earnings multiples of the general market. |
