🎙️ Talking Multiples

Multiples, Explained

One way to think about multiples is this: As a shareholder, the value of your stake is determined by the profits a business generates. If a business generates $100 in profit, and you pay $1,200 to buy the entire business, assuming the business doesn’t grow or decline at all, you will earn a return of ~8% every year ($100/$1,200.) The multiple of earnings you paid to generate an 8% return is 12 (12*$1,000.)

For this steady business, the multiple you pay determines your expected return, and you can find the expected return by dividing one by the multiple. 1/12 = 8% expected return. 1/20 = 5% expected return.

You might be very satisfied with an 8% return from a 12x multiple, but returns aren’t guaranteed in the real world. If you expect the company to earn $100 per year on average, with a low but meaningful risk of a new competitor disrupting their business such that the company may be only able to earn a return of $50 per year, then you’d probably not want to pay the full $1,200 to own the company.

You’d want a discount to account for the risk of competition reducing the company’s earnings and, thus, your returns. Perhaps, then, you’d pay a multiple of 10x earnings, or $1,000, such that in the best case scenario, you earn 10% per year ($100/$1,000) and in the worse case, you earn a satisfactory 5% return ($50/$1,000.)

The point is that the returns you earn from owning a business are a product of the multiple of today’s earnings you pay for it. If that same company will earn $100 this year but is doubling its profits every 12 months with nothing in its way to stop it, you might pay a premium for that future growth.

If you paid $4,000 to own the company, that would be a multiple of 40 (40*$100), leaving you with just a 2.5% return this year ($100/$4,000), but in five years, you’d own a company that was generating $1,600, which is a 40% return on your original investment. So, paying 40x earnings isn’t crazy at all for a super fast-growing business, where future earnings will more than recoup the opportunity costs of lower profits today.

Hopefully, you have the feel for multiples a bit better now. A multiple communicates investors’ required return, baking in assumptions about ongoing profitability and growth. Whenever you look at a price-to-earnings ratio, think of it through that lens.