UNDERSTANDING MULTIPLES AND
RATIOS IN TRADING

The sheer quantity of data available to those interested in using fundamental analysis can be overwhelming. Learn more about multiples and ratios and how they can be used to help you spot investment opportunities and monitor the progress of open positions.

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Trading multiples and ratios can be used to interpret a range of key information as a single number. These metrics are based on formulae that considers a variety of fundamental analysis and macroeconomic indicators. 

They also incorporate market data, allowing investors to effectively compare a company’s underlying prospects to its current stock price and establish if a stock is over or undervalued. 

What are multiples and ratios?

To put it simply, multiples and ratios are formulae that translate essential data points into a single, easily comprehensible number. They are used to assess various aspects of a company’s financial well-being, often by dividing one fundamental analysis metric by another. 

Multiples and ratios can utilise a range of data points, such as income statements and the cash flow data available on a company’s balance sheet.

For example, if you were to divide a company’s worth, otherwise known as its market capitalisation, by the dividend that it pays investors or its profit margin, you would end up with a trading multiple. This computation would generate a single number that can be tracked over time and compared against other firms, thus helping you to decide which stock to invest in.

Enterprise value multiples

Enterprise value (EV) multiples are used to establish a company’s fair value. Calculating enterprise value, rather than relying solely on market capitalisation, can allow investors to factor in other important elements of a company’s prospects, which may not be fully reflected in the current share price. These elements include debt obligations, something that any potential buyer of a stock should be interested to learn about.

Enterprise value multiples are commonly used by firms involved in mergers and acquisitions.

Equity multiples

Equity multiples are derived by dividing a company’s market capitalisation by a particular metric, for example its total earnings. In this specific case, the calculation would establish the price/earnings (P/E) ratio, a popular analysis tool among investors. 

Equity multiples are frequently used by investors looking to buy shares in a company.

How to use trading multiples in valuations

Trading multiples can be used to establish the intrinsic value of a prospective asset, indicating whether a stock is currently perceived as “cheap” or “expensive.” 

Since company reports follow standard accounting practices, the data sources will be similar between different firms. This enables investors to run relative valuations, for example, comparing the P/E ratio for one stock, such as Tesla, against the P/E ratio of another.

Examples of trading multiples and ratios

Studying commonly used metrics can allow investors to gain a clearer understanding of a company’s business model. 

Here are some of the most widely used multiples:

• EV/EBITDA: enterprise value / earnings before interest, taxes, depreciation and amortisation
  EV/EBITDA is a reliable multiple used by investors and analysts to assess a company’s value. It considers the market capitalisation of a stock, as well as the amount of debt on the balance sheet.

• EV/revenue: enterprise value / earnings
  This popular multiplier factors in a firm’s total sales and overall value. It proves particularly useful when a company has a negative EBITDA, especially during its early growth stage.

• P/E ratio
  This metric is similar to EV/revenue, but it uses the asset’s market capitalisation (stock price) rather than EV. As an example, the current 10-year P/E ratio for the S&P 500 index is around 30. 

• PEG ratio
  The PEG ratio divides the P/E ratio by the EPS (earnings per share) growth rate. A company in the growth stage will typically have a higher PEG ratio than a company that has reached maturity. 

Price is what you pay, value is what you get.

Warren Buffett

How can multiples and ratios be applied to a trading strategy?

Trading multiples and ratios can also be used to compare the metrics of other stocks within the same sector or a benchmark stock index, such as the S&P 500. This encourages you to take your analysis one step further, beyond merely identifying a promising investment opportunity. By considering alternative options, you can determine whether the potential investment is actually as good as you first thought.

Multiples and ratios offer an immediate take on which stocks are worth including on your short-list. By removing firms that do not make the cut early on, you can focus your efforts on building a strategy that includes those that do, therefore optimising your investment approach.

Limitations of multiples and ratios

Despite the apparent advantages of trading using multiples and ratios, it is important to remember that they are not always a perfect solution, and that traders and investors should not rely solely on multiples. Although they can provide a good indication as to the true worth of a company, multiples and ratios are primarily used by fundamental analysts. Technical analysts, who prefer to use price charts to find trading opportunities, will get less value out of these figures. 

External factors can also heavily impact multiples and ratios, and so a comprehensive analysis approach will oftentimes enable traders to get a better overall picture of a company and the value of its stock.

Final thoughts

Multipliers and ratios offer an opportunity to quickly grasp essential metrics relating to a firm’s business operations or stock price. The wide range of options available allows you to focus your investment approach on the factors that are most important to you.

Visit the eToro Academy to learn more about trading stocks.

Quiz

FAQs

Why do some stocks have an extremely high P/E ratio?

Growth stocks, representing firms with the potential to expand their market share and revenue streams, often exhibit relatively high P/E ratios. This is primarily due to investors’ expectations of significantly higher earnings in the future, compared to the present. As investors purchase the firm’s stock in anticipation of future returns, they drive up the stock price which, in turn, impacts the P/E ratio.

Which is more favourable, a higher or lower equity multiplier?

Investors typically look for companies with a low equity multiplier, as it indicates that the company is using more equity and less debt to fund the purchasing of assets. While companies with higher debt burdens do not necessarily need to be dismissed altogether, they can present riskier investment prospects.

Which is the best multiplier or ratio to use?

All multipliers and ratios are valuable, but the decision regarding which specific multiplier or ratio to use will mostly be determined by your personal investment aims and preferred strategy.

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