Getting to grips with the PE ratio: The difference between multiple expansion and multiple compression

Julie Brownlee, Fsp Invest, 02 Mar. 2015

Tags: pe ratio, multiple compression, multiple expansion, what is multiple compression, what is multiple expansion, financial ratios, investing,

One thing you may pay attention to when investing in a share is its price earnings (PE) ratio. This is a company’s current share price divided by its earnings.

It’s a way of gauging a share’s value.

A company’s PE ratio can go up and down. This is known as multiple expansion and multiple compression.

So why does this happen?

Read on to find out…

Multiple expansion explained

When you invest in a company’s shares, you want the share price to rise.

There are usually two reasons behind a share price rising:

  1. A company grows its profits.
  2. Investors are excited about a company’s growth prospects and will pay a higher multiple of its current profits.

A higher multiple means a higher PE ratio. Multiple expansion is when a PE ratio rises.

When shares and markets become more expensive, their PE multiple rises too.

The ins and outs of multiple compression

On the other hand, there is multiple compression. This is when a PE ratio falls.

When PE ratios continue to rise, there’s a higher chance of multiple compression and a higher chance of big losses.

That’s because there are less investors prepared to buy at higher prices.

There are a number of things that can lead to multiple compression. One reason is rising political tension.

Another reason is rising interest rates. When interest rates start to increase, prices of most investments fall. This means that even if a company’s managing to grow its profits, its share price can fall.

Let’s say a company has a PE ratio of 20. If you invert this (1/20) to get the earnings yield or interest rate, you get 5%.

If interest rates rise by 2%, investors now want a higher earnings yield. In our example, they’d want 7%. That means the PE ratio would dip to 14.3 times (1/7).

So there you have it, the difference between multiple expansion and multiple compression.

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