Earnings Multiplier

The earnings multiplier, or the price-to-earnings ratio, is a method used to

compare a company’s current share price to its earnings per share (EPS). It is
used as a valuation tool to compare the share price of a company with that of
similar companies.

The earnings multiplier also shows how much an investor will be paying for one
dollar earned by the company. The earnings multiplier can be used to assess a
company’s financial health. The price-to-earnings ratio of several companies can
be compared while making investment decisions.

Formula of the Earnings Multiplier

The earnings multiplier can be calculated using the following formula:

Earnings Multiplier or P/E Ratio = Price Per Share/ Earnings Per Share
Where, Price per share is the prevalent market price of a company’s stock. It is
the price at which the company’s shares are trading in the exchange market.
Earnings per share is the net profits earned by the company per share
outstanding in the stock market.

Types of Earnings Multipliers

The following are the two most common types of earnings multipliers:

1. Forward Earnings MultiplierAlso called the estimated earnings

multiplier, it is used to compare the present earnings with future earnings. It
provides a clear picture of the company’s earnings in the future – assuming no
changes or adjustments. However, companies may either overestimate or
underestimate their earnings to meet the expected earnings multiplier. Market
analysts also come up with estimates for earnings multipliers, which may be very
different from the company’s estimates, resulting in confusion.
2. Trailing Earnings Multiplier It depends on the company’s past
performance, considering a 12-month period for calculations. It is the most
commonly used price-to-earnings indicator, as it is based on facts assuming that
the reported earnings are accurate. Investors prefer the tradings earnings
multiplier, as they often lack faith in estimates presented by others. However, the
past performance of a company does not always reflect its future performance.
If the forward earnings multiplier is lower than the trailing earnings multiplier, it
implies that the analysts are predicting an increase in the company’s earnings.
Conversely, if the forward earnings multiplier is higher, the analysts are
predicting a decrease in the company’s earnings.
 Economic Value Added

Economic Value Added (EVA) or Economic Profit is a measure based on the

Residual Income technique that serves as an indicator of the profitability of
projects undertaken. Its underlying premise consists of the idea that real
profitability occurs when additional wealth is created for shareholders and that
projects should create returns above their cost of capital.

EVA adopts almost the same form as residual income and can be expressed as
follows:

EVA = NOPAT – (WACC * capital invested)

Where NOPAT = Net Operating Profits After Tax

WACC = Weighted Average Cost of Capital

Capital invested = Equity + long-term debt at the beginning of the period

and (WACC* capital invested) is also known as finance charge

Calculating Net Operating Profits After Tax (NOPAT)

One key consideration for this item is the adjustment of the cost of interest. The
cost of interest is included in the finance charge (WACC*capital) that is deducted
from NOPAT in the EVA calculation and can be approached in two ways:

1. Starting with operating profit, then deducting the adjusted tax charge (because
tax charge includes the tax benefit of interest). Therefore, we should multiply the
interest by the tax rate and add this to the tax charge; or
2. Start with profit after tax and adding back the net cost of interest. Therefore, we
should multiply the interest charge by (1-tax rate).

Accounting Adjustments

Three main adjustments should be made. Among the most common and
important are:
 Expenditures on R&D, promotion, and employee training should be capitalized.
 Depreciation charge is added back to profit and instead, a charge for economic
depreciation is made. This reflects the true change in the value of assets during
the period, unlike accounting depreciation.
 Accounts such as provisions, allowances for doubtful debts, deferred tax
provisions, and allowances for inventory should be added back to capital implied.
 Non-cash expenses should be added back to profits and to capital employed.
 Operating leases should be capitalized and added back to capital employed.
 Tax charge will be based on cash taxes, rather than the accruals-based methods
used in financial reporting and will be calculated as follows:

Tax charge per income statement – increase (or + if reduction) in deferred

tax provision + tax benefit of interest = Cash taxes

Calculating the Finance Charge

Finance Charge = Capital invested * WACC

and WACC = Ke*E/ (E+D) + Kd (1-t)*D/ (E+D),

where Ke = required return on equity and Kd (1-t) = after tax return on debt

Thus, given the adjusted taxes, we can write the economic value-added formula
as follows:

EVA = NOPAT – (WACC * capital invested)

Properties of Economic Value Added

The properties of using economic value added can be compared with other
approaches in the following table: