The Earnings Multiple Approach to Valuation
One of the quickest ways to check the valuation of a stock is to look at its price-to-earnings ratio (P/E), also known as the earnings multiple. This is probably the most common and efficient way to assess whether or not you are paying too much for a stock. This article will explain how to quickly assess the value of a stock with the earnings multiple approach to valuation.
What is the Earnings Multiple and How to Calculate It?
In simple terms, the earnings multiple is the stock price divided by earnings per share (EPS), and the units are expressed in years – that is, how many years of those earnings it would take to equal that stock price.
For example, if a stock is $50, and its EPS is $2.50, then the earnings multiple is $50/$2.50 EPS = 20. The stock price is expressed in dollars, the EPS is expressed in dollars per year, so the earnings multiple of 20 is expressed in years. It would take twenty years of $2.50 each year to get $50.
Of course, the earnings multiple alone doesn’t tell us much. If the company is growing its EPS each year, then in reality it will take less than that number of years for cumulative EPS to sum to the current stock price. Therefore, what constitutes a “fair” earnings multiple depends on several factors like growth and stability. Depending on the sector and type of company, a “fair” P/E ratio is completely different. We’ll get there later in this article.
The Earnings Multiple Valuation Approach
Having an intuitive understanding of what constitutes a “fair range” of earnings multiple for a stock allows an investor to calculate some scenarios about future stock price.The method is to estimate EPS growth over a period of years. Then place a hypothetical earnings multiple on the EPS figure at the end of that period. Finally, compare that hypothetical stock price to the current stock price, which can allow for quick calculation of expected rate of return over that period. There are three components to the final value:
1) The final stock price at the end of the period.
2) Cumulative dividends received over that period.
3) The impact of cumulatively reinvesting those dividends.
An Example of the Earnings Multiple Valuation Approach
Suppose a railroad company, called “DM Rail” currently has EPS of $2, pays annual dividends of $1, and has a stock price of $40. Since 40/2 is 20, the earnings multiple is 20.
You think that may be a little bit high and would rather see a lower earnings multiple. You decide to look at the track record of growth along with the future company plans to make a 10-year estimate. Based on previous growth, management goals for EPS growth, explanations of how they’ll reach those goals, and other factors, you estimate a 10% rate of EPS growth over the next ten years. You then assume that the dividend payout will stay the same, so the dividend also grows by 10% per year.
The table of growth would like something like this: