Multiple Compression
What Is Multiple Compression?
Multiple compression is an effect that happens when a company's earnings increase, but its stock price does not move in response. Pursuing this direction, assuming that the company posts flat earnings, the stock price could fall or in some cases, the stock price drops faster than the earnings. The result is that its price multiples, like its P/E ratio, are reduced since the denominator increases while the numerator remains the same, even however nothing might be fundamentally amiss with the company.
The compression of a company's multiple can be interpreted as a company's valuation being called into question or a change in investor expectations.
Understanding Multiple Compression
A price multiple is any ratio that uses the share price of a company related to some specific per-share financial metric for a snapshot on relative valuation. The share price is then divided by a chosen per-share metric to form a ratio. Price multiples enable investors to evaluate the market value of a company's stock in relation to a fundamental [metric](/metrics, for example, earnings, cash flow, or book value (P/B). Compression happens when these multiples shrink.
Multiples are based on several factors, but most importantly on the future expectations of a company. On the off chance that a company trades at say, a P/E multiple of 50, this means investors are paying $50 in equity for each $1 of earnings. Generally, an investor would just pay such a high multiple on the expectation that the company will become essentially faster than its competitors or the stock market in general.
When the company's growth rates begin to slow, investors could begin to doubt its growth prospects, and consequently not pay as expensive a premium as they once did. Expectations about future prospects can be dashed in the event that a company misses earnings or gives negative forward guidance.
Example of Multiple Compression
In the case above, our hypothetical company begins with a P/E of 50. The company could experience multiple compression assuming it releases earnings that are double the previous earnings per share (EPS). Meanwhile, the stock price remains the same. The P/E will consequently be reduced to 25, even however earnings have improved. With the same dollar of earnings, this would mean that the stock's relative value has been cut in half (25/50 = 1/2).
Alternatively, assume the company releases earnings that are exactly the same as the prior earnings, but the stock price falls by half. The result would be the same in terms of the P/E. This demonstrates how the stock price could go down when earnings stay the same.
Highlights
- Multiple compression can happen assuming that share prices fall while earnings stay flat or on the other hand assuming that share prices remain the same while earnings increase.
- Multiples like the P/E ratio are used to analyze a company's relative valuation in the market.
- Multiple compression happens when a company's financial multiple decreases, often representing a change in investor expectations.
