Making Money With Multiples

Spend long enough in investing circles, and you'll hear the term "multiple" tossed around. Wondering what it means? Here's a quick primer.

"Multiple" basically refers to a number that compares one of a company's vital statistics to another. The most common example is the price-to-earnings (P/E) ratio, frequently referred to as the "earnings multiple."

Let's use Amgen (NASDAQ:AMGN) to illustrate. It was recently trading for around $63 per share, and its trailing 12-month earnings per share (EPS) was $3.88, excluding extraordinary items. Divide $63 by $3.88, and you'll get a P/E ratio of 16.2. You could also say that Amgen's recent price was 16.2 times its EPS, or that it's trading at a multiple of 16.2. Got it?

Multiple multiples
The P/E is just one of many multiples. The price-to-sales (P/S) ratio, in which you divide a company's market capitalization by its trailing 12-month revenue, is useful for evaluating companies that aren't yet profitable. There's also a price-to-book value multiple, a price-to-cash flow multiple, and so on.

You can find particularly promising companies by searching for low multiples and solid expected growth rates for EPS. That can give you a one-two punch: The low multiple will presumably catch up with itself, which it can only do if the stock price rises or EPS shrinks. And growing EPS can also fuel stock-price appreciation.

Imagine Meteorite Insurance (Ticker: HEDSUP), trading at $20 per share with EPS of $2 per share. Its P/E would be 10 (20 divided by 2). As earnings grow, its stock price will likely follow suit. So when EPS hits $4, if the P/E ratio has held steady, the stock might be in the $40 range. Now imagine that the P/E has risen closer to its historic mean, or to its industry range, becoming 15. Given an EPS of $4, that would imply a stock price in the neighborhood of $60.

Screening for multiples
Multiples can also help you screen for promising stocks. Here are some of the ideas I found when searching for large-cap companies with price-to-cash flow (P/CF) ratios below their industry average, and hefty net margins that have risen over the past three years.

Data: MSN Money, Motley Fool CAPS.

Note two caveats, though. First, these ratios don't reflect free cash flow -- a metric that takes into account money spent on capital expenditures. Also, not all of these stocks are equally well-regarded by our Motley Fool CAPS community of investors. In short, don't take this as an automatic buy list -- just a starting point for your own further research.

Don't multiply a mistake
Bear in mind that a low multiple doesn't guarantee you a great stock. Some multiples are low for good reason -- value traps that can end up leading you to underperformance. Among the red flags to beware in companies with low multiples:

• Inconsistent earnings power
• Lots of debt
• Weak competitive positions

Low multiples are a generally a promising sign, but you should always follow up with your own due diligence.

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