What it is:
How it works/Example:
Let's look at an example to illustrate the concept.
Assume that Big Store's stock is trading at $14 and the company's earnings per share (EPS) is $2. Therefore, Big Store's price-to-earnings ratio (P/E) is $14/$2 = 7. This number -- "7" -- is known as a multiple.
Here's how you could use it in your analysis:
Assume the average P/E ratio for the companies in Big Store's industry is 10. By applying the average industry multiple to Big Store's earnings per share (EPS), you can estimate the price Big Store "should" be trading at a higher price. Here's the calculation:
Price = EPS * Multiple
Price = $2 * 10 = $20
In this example, it appears that Big Store's stock price should be trading at $20 instead of $14. If your analysis is correct, you would want to buy the company today and wait for the price to adjust to where it "should" be, locking in a healthy $6 gain.
Why it matters:
Multiples are quick, but limited tools for stock analysis. They can provide a snapshot of a stock’s potential without getting bogged down in the details of the financial statements.
Unfortunately, most of the useful details are in the financial statements. For example, Big Store may trade at a lower multiple relative to its peers because it isn't growing as fast. Or perhaps its management team is not as effective. If you only use theintrinsic value, you're working without 99.9% of the available information.multiple to estimate the stock's
The bottom line is that multiples can be complementary tools in your financial toolbox. However, they should never be the only tools you use.