Imagine you're researching Downsizers Diet Centers Inc. (ticker: SLIMM), and you read that "it deserves to trade at 28 times trailing earnings, or about $56 today. If it maintains 18% earnings per share (EPS) growth, it appears to be a bargain right now." You were doing fine until this sentence, but now you're flummoxed. The concepts involved are simple and valuable, though, so let's clear them up.
The word "multiple" usually refers to a company's price-to-earnings (P/E) ratio, which as you probably know by now is its current stock price divided by its earnings per share. If a company has a P/E of 28, people will say that it's trading at "28 times earnings" or at "a multiple of 28." (Learn more about what the P/E ratio is.)
Savvy Fools often examine a company's multiple and compare it with what seems to be a fair multiple, given its industry and competitive position. Let's say that Downsizers' peers all have multiples in the high 30s, and its own multiple is in the low 20s. A low multiple can be promising, suggesting that the stock is undervalued and that the price will increase as the multiple catches up to its peers. (It can also indicate that the firm is losing in the marketplace or has other problems, though.)
Also auspicious are briskly growing earnings. Earnings growth drives stock price growth. Rapid growth can even make up for a relatively high multiple. How fast earnings grow is also a good indicator of how high a company's P/E should be. In other words, a company doubling its earnings each year deserves a higher P/E (or "multiple") than a firm growing gradually.
Expected earnings growth coupled with P/E-multiple growth can offer a powerful one-two punch. (Warning: numbers ahead!) Imagine a stock trading at $10 per share -- 10 times its EPS of $1. As earnings grow, the stock price will likely increase to maintain the multiple. For example, when earnings are $2 per share, the stock price should be near $20. But if the multiple is also growing, the price is likely to increase even more. If a reasonable multiple is perceived to be more like 15 and the earnings are $2 per share, the stock should eventually approach $30 per share. Companies generating above-average earnings growth and trading at below-average P/E ratios can make for great investments.
Finally, understand that there are other kinds of multiples. If you read analyses of various companies, you'll see references to price-to-sales multiples, book value multiples, cash flow multiples, and more. It's instructive to compare a company's various multiples with those of its competitors.
Learn why the P/E ratio isn't as valuable as you may think -- in these two articles: part 1 and part 2. You can learn more about how the financial world works in our Investing Basics area and in our Fool's School.
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