A market multiple is another name for the investment term price-to-earnings ratio. This ratio compares a company’s current stock price against its current earnings per share. The basic calculation for the market multiple is market value per share divided by earnings per share. For example, a company whose current stock price is $22.00 US Dollars (USD) and current earnings per share of $1.40 USD has a multiple of 15.70. The multiple is often a predictor of future stock price movement.
Investors often calculate the market multiple using a company’s current quarterly information. Most companies release their earnings per share quarterly, making this the best time to obtain the necessary pieces of information. In some cases, a company may provide information on a monthly or trailing 12-months basis. Using this information to calculate the multiple ensures the investor has the most up-to-date information when comparing data on a company’s stock.
The market multiple allows investors to create future forecasts for a company’s stock price. For example, in the previous example, a company’s market multiple is 15.70 based on current $1.40 USD earnings per share. Most times, a company will provide future estimates for the next quarter’s earnings per share. If the company expects earnings to reach $1.75 USD per share, the stock price should be equal to the market multiple times the expected earnings per share. The new stock price should then be $27.48 USD at the end of the next quarter.
Increases in a company’s stock price are typically where most investors make money. Using the market multiple approach, investors can determine whether stocks in their portfolios will increase or decrease in price through the next quarter. Investors may then buy or sell stocks in order to maximize the expected gains calculated using the multiple approach. Another term for this approach to this stock analysis is known as the earnings multiple approach. A large benefit from this method comes from information readily available on numerous stocks traded through exchanges.
Though simple in its approach, the earnings multiple method is not without its flaws. Among the most problematic issues is the use of accounting information to determine net income, which is how a company ultimately calculates earnings per share. Public companies may attempt to manipulate their net incomes using aggressive or illegal accounting procedures. This can distort a company’s earnings per share and lead investors to make decisions on false premises. Companies with high noncash expenses — such as depreciation or amortization — can also artificially lower net income, making a company look less profitable and decreasing earnings per share.