Earnings Multiplier Approach

Posted By: Advisor Analyzer Team

The P/E ratio is a commonly utilized tool for equity analysis. The Earnings Multiplier Approach is a means to forecast future earnings of a company, and consequently the estimated P/E ratio. To calculate the earnings multiplier, we multiply the aggregate earnings by the P/E to market value.

 

To derive the P/E estimate, we use the Dividend Discount Model (DDM):

(P0)/(E1) = (D1/E1)/(Ke – g)

 

P0 = Price of Security

E1 = Projected Earnings in the next year

D1 = Dividend estimated for the next year

Ke = Required Return on Equity Capital

g = Growth Rate

Step 1: Estimate Sales per Share

Start with the estimate of GDP forecasted for the coming year. This information is usually provided by governments, banks and economists. Given the GDP estimate we can now estimate the firm’s expected sales per share for the coming year. To do so, we must assess the stock market series based on the historically strong relation between sales and GDP using regression analysis.

Step 2: Estimate Profits

Once we have obtained the sales estimate of the company, profit margins can be calculated based on recent earnings trends. This information is usually offered on a quarterly and annual basis by all publically traded companies as required by the SEC. However it should be noted that net profit margins are earnings net of taxes, depreciation and amortization and interest payments. These rates will change frequently, depending on the company’s depreciable assets and capital expenditures, earnings and taxes owed, and overall capital structure of the firm. This usually results in earnings per share volatility, even if revenues are constant. Therefore, earnings before interest, taxes and depreciation (EBITDA) should be used first to measure operating profits.

Step 3: Estimate Depreciation, Amortization

Depreciation is a tricky component, since most companies generally increase their capital expenditures over time. We can find depreciation estimates by using time series analysis with capital expenditures (CAPEX) as the independent variable. If the CAPEX is currently high, the depreciation is expected to grow above average. Alternatively, we can estimate depreciation using the Plant Property and Equipment and applying the appropriate depreciation rate to that PP & E amount. The main reason we do not include depreciation in the previous step, is that depreciation should not be calculated as a percentage of sales, since it is dependent upon the level of capital investment.

Suppose an investor with an ordinary income tax rate of 25% purchased stock XYZ on three separate occasions: 100 shares two years ago, 100 shares one year ago, and 100 shares yesterday. The individual decides to rebalance his portfolio and would like to sell half of his position (150 Shares) in XYZ. Since he has purchased the XYZ on different dates, he is able to select which lot to sell and which to hold. If the investor sells the position he purchased yesterday (i.e. last in first out), there will be a short term capital gain tax applied at his ordinary income rate. However, if the investor chooses to sell the lot from two years ago and half the lot from last year, they are both subject to long term capital gains taxes which results in lower taxes paid.

Step 4: Estimate Interest expense per share

Interest expense is a function of the outstanding debt and expected market interest rates. These debt levels can be used to estimate the firm’s asset levels. However, the debt outstanding and current market interest rates are not the only relevant factors for a borrowing firm. The credit rating of the company, the overall trend of their credit history are also major factors that impact the firm’s cost of borrowing, and should be given equal credence when developing expectations. Similar to Depreciation and Amortization, interest expense should not be estimated as a percentage of sales, as it is more tied to the firm’s credit rating, debt levels and market interest rates.

Step 5: Estimate Corporate Tax Rates

Estimation of the corporate tax rate should be fairly straight forward, but consideration to the current and future political environment should be noted. Taxes should be adjusted for any possible tax legislation due going forward. Taxes should be calculated as a percentage of sales.

Step 6: Putting it all together

When we combine the relevant factors of a company’s income statement, we are able to estimate the predicted EPS of the company with the following equation:

EPS = [(Sales Per share estimate)(EBITDA) - Dep. & Amort. –Interest] (1 – Taxes)

Using the EPS estimate, we are able to evaluate a company’s stock price relative to its earnings. It’s a tool to determine if a company is trading “cheap” or “rich” to its peers. While far from bullet proof, the earnings multiplier approach is a useful tool for those who already use the P/E ratio.