Price earnings multiple definition

/

What is the Price Earnings Multiple?

The price earnings multiple compares the earnings per share reported by a company to the market price of its common stock. This multiple is used by investors to judge how expensive a share of the company's stock is. During a declining market, the overall price earnings multiples tend to decline for the shares of all companies, with the reverse occurring when the economy is expanding.

When the Price Earnings Multiple Increases

There are several circumstances under which the price earnings multiple for a business will increase, including the following:

  • Expectation of greater earnings. Investors tend to bid up share prices, which increases the price earnings multiple, when there is an expectation of greater earnings in the future, even if the issuing entity is not currently reporting increased earnings per share.

  • Reported earnings beat estimates. This can occur when a promising new product or service is released or announced. The multiple may also increase when the reported earnings per share exceed the expectations of analysts.

Related AccountingTools Courses

Corporate Finance

Investor Relations Guidebook

Public Company Accounting and Finance

When the Price Earning Multiple Decreases

The price earnings multiple is more likely to decline under any situation where a firm’s future earnings per share will probably decrease. Here are several examples:

  • Poor earnings. A business predicts disappointing earnings in its most recent earnings conference call.

  • Increased competition. A competitor releases a product that will directly compete with the company’s products; a future earnings decline is therefore to be expected.

  • Reduced trade barriers. The trade barriers with another country are removed, which increases the risk of price competition.

  • Lawsuit filed. A lawsuit with a potentially large payout is filed against the company.

  • Harmful regulations. The government approves new regulations that will harm the firm’s operations.

In all of these scenarios, investors are likely to conclude that a firm’s earnings will be depressed, and so bid down the price of its stock. The result is a decrease in the company’s price earnings multiple.