* When I first started investing, I just didn’t understand the concept behind the Multiple and how it contributed to returns (or losses) for a stock. This is not about the investing strategy you adopt such as buying undervalued companies based on P/E or buying growth companies based on P/S. This is just a simple short explanation of the impact of Multiple Expansion or Contraction on stock prices.

What is Multiple Expansion and Contraction?

Understanding the impact of multiples on stock prices is an essential part of valuation. Multiples like price-to-earnings, price-to-sales, and EV/EBITDA are used to interpret a company’s performance, financial health, operating efficiency, profitability, or returns.

Multiples can be seen as a “speculative return” because they are based on the value placed on a stock by the market. This idea was popularised by John Bogle who believed that Investment Returns are very different from speculative returns.

Multiple expansion happens when the valuation of a stock rises faster than the stock’s fundamental value.

Two ratios that provide insights into multiples are the P/E (price-to-earnings) ratio and the P/S (price-to-sales) ratio. You can learn more about ratios here ➡️ Investment Ratios.

If Investors are more risk-averse, multiples will be lower ⬇️

If Investors are less risk-averse, multiples will be higher ⬆️

The P/E multiple indicates how much investors are willing to pay for every dollar of earnings. A higher P/E ratio suggests that the market is more optimistic about the earnings, so it places a higher value on every dollar. This can lead to a multiple expansion. When earnings start to grow, investors’ sentiment improves, pushing the multiple higher. If investors lose confidence in the business, regardless of fundamentals, the P/E ratio will decrease, known as a multiple contraction or compression.

The P/S ratio tells us how much investors will pay for every dollar of sales. If investors expect revenue growth, then multiple expansion occurs, as investors are willing to pay more for every dollar of sales.

Why is understanding the impact of Multiples important?

As an investor, it’s important to understand the impact of multiples on stock prices and valuations. Multiples driven by speculation and market sentiment can impact stock prices, regardless of a company’s underlying value.

To be a Stoic Investor, you need to focus on buying companies based on their underlying fundamentals rather than on market sentiment. However, the speculative return has started to drive shareholder returns, which means that investors are willing to pay more or less for a company’s earnings or sales in different markets.

Multiple Expansion happens when the market recognizes an opportunity in investment, and it can be driven by changes in a company’s fundamentals. Conversely, multiple compression can happen even when a company’s earnings increase if the share price doesn’t respond accordingly.

Investor expectations and sentiment can greatly impact stock valuations. If a company’s reported earnings or sales figures are brought into question, investors can drive the multiple down. Regardless of whether the figures are positive or negative. In short, it’s essential to understand the impact of multiples on stock prices and valuations to make informed investment decisions.

Do you want to pay more or less for the profits?

When the P/E multiple goes up, you end up paying more than you used to for the same profit. This means that the company is now being valued more highly in the market. For instance, a P/E multiple of 10x means that you are paying ten times the company’s profits. This means that the company is worth ten times the earnings it generates. Another way to look at this is in terms of years. A P/E of 10x would mean that it would take you ten years to get your investment back if the profits remained the same.

When the P/E multiple expands due to excitement or investor confidence, it means that you are paying more per share of the profits. If it increases to, say, P/E 20x, you are now expecting a 20-year wait to return your investment (all things being equal).

However, when the P/E expands without any clear reasoning, it may expose the investor to risk. This is because the results are now dependent on the market. If investors lose faith in the company, it can compress the P/E multiple.

The Multiple Expansion is not something that can be predicted.

I suppose that is where the “speculative” aspect comes in. There is no way to know whether investors are going to become more optimistic (or pessimistic) about a stock.

When investors flock to an investment with optimism the price of the stock (Numerator) expands faster than the growth in the denominator (either earnings or sales). This leads to the stock becoming more expensive. For example, a stock with a P/E of 5x going to 20x means investors are willing to pay 4x the price for the same amount of earnings.

Multiple expansion is what you want. Regardless of speculative return. If you are buying companies at lower valuations that have not been recognised by the market and that company starts to deliver, then a combination of Fundamental Growth and Multiple Expansion can deliver outsized returns.

An example of how the Multiple Expansion impacts share prices.

Let’s create a hypothetical example to show how a Price-to-Earnings Multiple can drive the share price. Starting with the following baseline and looking at a small-cap stock that we believe will grow into the future.

• Current Share Price: $15.50
• Earnings Per Share: $1.10
• Dividend: $0.25 Cents
• Dividend Yield: 5% Annually
• EPS Growth: 5% Annually
• Holding Period: 5-Years
• Starting P/E Multiple: 15x

	Year 1	Year 2	Year 3	Year 4	Year 5
EPS	$1.16	$1.21	$1.27	$1.34	$1.40
Dividend:	$1.05	$1.10	$1.16	$1.22	$1.28

To summarise this after 5 Years and assuming no movement in the P/E multiple our new share price is $21. Year 5 EPS multiplied by the P/E ($1.40 x 15x = $21).

Now if we add in all the dividends received ($5.80) we have a total return of $26.8. This works out to a Compound Annual Growth Rate (CAGR) of 8.54%. The math using the CAGR formula is ($26.8/15.5)^(1/5)-1 x100.

Though this is a simple example based on a similar investment let us look at the above figures however with wildly different market expectations. This is where everything we have learned about the market comes into play. If the Market places a different multiple on those earnings here is what happens.

The outcome of a changing Multiple.

Price-to-Earnings	P/E 5x	P/E 20x	P/E 32.5x
Share Price after Year 5	$7.02	$28.08	$45.63
Dividends Received	$5.80	$5.80	$5.80
Total Returns	$12.82	$33.88	$51.43
CAGR	– (3.09)%	17.70%	27.95%

We can see how the changes in the Multiple can produce entirely different returns based on what value the market places on those earnings.

We can either have a multiple contraction as in the case of the P/E 5x which created a loss. This could be caused by the business falling out of favour with investors. I find this a lot at the smaller end of the market. I would say it is a patience game. Small companies take time to deliver even though they may be doing well with positive results.

Now look at the P/E 32.5x which can be caused by the market placing a higher value on the future earnings of this business. This Multiple Expansion contributes significantly to the returns the investor receives. While the Multiple Expansion may be a Speculative return, it still matters.

A word of Caution…

Investing in companies that primarily depend on multiple expansion for generating returns can be quite risky. It’s important to ensure that the growth in share price is supported by growth in revenue, earnings, and ultimately free cash flow. These are the factors that drive long-term shareholder returns. Companies that lack these qualities are dependent on the market to push up their stock price, which creates volatility.

Investors can change their perception of a company’s value overnight and start pushing up (or down) the share price by simply paying more for less earnings or sales. This is where having a disciplined investment process and maintaining a focus on value is crucial but often overlooked. While having a rigorous process may cause you to miss out on some returns, it also safeguards you from taking too many risks.

In the past, I’ve made returns on investments that I couldn’t explain, and which were based solely on speculation and high risk. Often, these returns were dependent on other investors pushing up the multiple to create value. However, over time this becomes more challenging to depend on. Multiple expansion can create value when combined with increases in the right business metrics. These are more tangible sources of value.

The Multiple is simply a reflection of the market’s perception of a stock’s prospects.

Taking a closer look at the P/S ratio, which is often used to evaluate hyper-growth companies and early-stage small-caps. If a business experiences an increase in sales while its P/S ratio remains the same, the share price will increase to reflect the rise in revenue. On the other hand, if sales remain constant but the P/S multiple expands, the share price will increase to account for the rise in the multiple.

This is where the Multiple comes into play. If the market becomes overly optimistic about a business, it can drive up the Multiple to high levels. This increase in the multiple causes the share price to rise in tandem. Essentially, investors are willing to pay more for each dollar of sales, regardless of any changes in the business.

Investors expect that the future performance of the business will justify paying a higher price now. That is the bottom line. If an investor believes that a company will have higher earnings or sales in the future, they will be willing to pay a higher multiple for it today. Conversely, if they believe that the business’s prospects look bleak, they will pay a lower multiple for it.

The higher the required return of a business, the lower the multiple an investor would prefer. Conversely, the higher the growth of a business, the higher the multiple an investor would want.

Multiple Expansion in Small-Cap stocks can be wonderful.

I have found that investing in small-cap stocks with great growth potential can generate significant returns. Let’s assume a business is growing its revenue, and earnings and working towards free cash flow. We then purchase this business at a reasonable valuation based on its prospects. If we hold onto it as the business increases in value in combination with a Multiple Expansion, it can result in outsized returns.

As the company gains recognition, investors start paying attention. This drives up the share price which results in a multiple expansion.

In my opinion, this multiple expansion in small-caps is justified. These companies are often undervalued due to less coverage and higher perceived risk. This keeps quality investments out of the spotlight.

During tough economic conditions, people tend to invest in safer options. This causes the underlying fundamentals of these companies to be overlooked. However, when the business is recognised for its true value, the appropriate multiple is placed on it, leading to higher returns.

It is important to note that while multiple expansion can drive short-term returns, strong fundamentals such as revenue and earnings growth, combined with the right valuation, are necessary for long-term returns. The multiple expansion is more evident in bull markets, where investors are willing to pay more for less earnings.

In Summary…

It is important to understand the effect of the multiple, whether it is expanding or contracting. Regardless of whether you are interested in Investment Return or Speculative Return, a combination of both is desirable.

If you are a value investor, you rely on the multiple expansion to make a profit. If you are a small-cap investor, you are depending on recognition from the market to drive the value higher. As a growth investor, you want the higher multiples to be met with the delivery of growth in revenue and earnings.

Even if stocks seem expensive due to high multiples, they may be justifiable due to their growth potential. Buying stocks that are overvalued and trading at 52-week highs can still lead to good returns if the multiple increases as more investors are attracted to the opportunity. Therefore, it is crucial to examine the business performance to ensure that market expectations align with the company’s forward-looking growth.

Over the past decade equity returns have started to be driven by Multiple Expansion. So it is something to consider when evaluating investments. Ensure you are valuing the fundamentals of the business and not making decisions based on what value the market places on it.

Hopefully, this gives you an idea of the power behind the multiple and gives you something to consider when looking at investments.