The equity multiplier is a useful tool for investors to monitor risk and understand how a company generates returns for investors. It's helpful by itself and as part of a DuPont analysis, which is a financial tool that breaks out how a company generates a return on equity (ROE).
What is the equity multiplier?
The equity multiplier is a financial ratio used to measure how a company finances its assets. Simply put, it's the assets of the company divided by shareholders' equity rather than debt.
A low equity multiplier implies a relatively small amount of debt (as the share of assets financed by shareholders' equity is relatively high). Conversely, a high ratio suggests a relatively high amount of debt (since the share of assets financed by shareholders' equity is relatively low).
A simple way to remember this is that a rising equity multiplier implies a company is taking on relatively more debt.
Illinois Tool Works | 2013 | 2022 |
|---|---|---|
Equity Multiplier (assets/shareholders equity) | 2.06x | 4.99x |
Sales/Assets | 0.7x | 1x |
Income/Sales | 11.9x | 19x |
Return on Equity | 16.6% | 90.4% |
A rising equity multiplier is obviously a concern. Still, the company has also significantly improved its profitability (income/sales) and how much sales it generates from its assets (sales/assets) over the same period. In other words, Illinois Tool Works is excellently sweating its assets, even if those assets were supported by taking on more debt.
In this case, the rising equity multiplier is not such a concern.
However, suppose the equity multiplier had risen while sales/assets and income/sales were static or declining. In that case, it's possible ROE could have increased because the company was taking on debt.
This is not a problem while the interest rate environment is benign, but it's a risky strategy when conditions change. As such, keeping an eye on the equity multiplier in the context of how a company generates earnings is a good idea. It tells you a lot aout the direction of a company.
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