Multiple compression is when a firm’s price/earnings ratio falls even without a fundamental change in that firm’s standing. There are several reasons why this might happen, most notably that a firm which has been rapidly growing hits a natural peak in growth rates. Investors who simply look at statistics without understanding the multiple compression effect may then mistakenly believe the firm’s stock has a bleaker outlook.
The multiple is another name given to a firm’s price-to-earnings ratio. This is calculated by dividing the current market price of a share by the earnings per share. This latter figure is usually calculated by dividing the company’s annual profits by the total number of shares.
The multiple is one of the figures commonly printed for each stock listed in the market data section of financial newspapers. At its most basic, the multiple is a quick guide to whether the current market price is good or bad value. Assuming a company pays dividends in line with actual earnings, the multiple is the number of years it will take for an investor’s dividends to match their initial investment.
Of course, many investors don’t put all their attention towards dividends. Some or all of their priorities will be for the likelihood of selling stock at a profit after its market price rises. For these types of investor, a high multiple can be seen as a positive. This is because of the theory that the multiple is so high because other investors are very confident that the firm will continue to grow rapidly.
It’s common for firms which become very successful shortly after their launch to have extremely high multiples. One area this happens is in tech and Internet firms which can often quickly increase their revenues without as rapid an increase in costs. However, many such firms eventually reach the point when they cannot expand as quickly any more. For example, they may have reached saturation point in a particular market and find it difficult to attract as many new customers each year. It’s important to note that a company in this position may still be extremely profitable: it’s only the rate of expansion which has slowed.
The problem is that investors will often realize that the growth rate is likely to slow. At this stage, they will no longer be prepared to buy the stock at such a high multiple. As long as the company’s earnings remain the same, the only way for this multiple to lower is for the stock price to lower. This effect is known as multiple compression.
As an example, imagine a company with a stock price of $30 US Dollars (USD) and annual earnings per share of $1 USD. This means its multiple is 30. If the company’s future growth appears limited, would-be investors may decide not to buy the stock unless the multiple drops to 20. Unless earnings change, the stock price will have to drop to $2 USD before investors buy. Of course, this is very simplified as in reality factors other than multiple compression affect stock prices.
Multiple compression can become something of a self-fulfilling prophecy. Less experienced investors may not understand that a multiple falling in this way does not always mean the company itself is performing badly. This may mean investors lose confidence in the stock, driving its price further downwards; this in turn drives the multiple downwards.