When you buy a share in a company, you probably hope that the price will go up. This usually happens for two reasons: the company’s profits may rise, making it more attractive to investors; but more often, the price rises because investors get more excited about the company’s growth prospects and so are prepared to pay a higher multiple of its current profits – a higher price/earnings (p/e) ratio – to buy the share. This is known as multiple expansion.
As shares and markets get more expensive, their p/e multiple rises. Multiple compression is the reverse – falling p/e ratios. High p/e ratios increase the risk of multiple compression and the chances of big losses. That’s because there are fewer people around willing to pay ever-higher prices.
Multiple compressions can be triggered by nasty surprises, such as political tension rising. Rising interest rates also tend to drive the prices of most investments down. So share prices can fall even if company profits are still growing. Say a share has a p/e of 20. Invert this (1/20) to get the earnings yield or interest rate – in this case, 5%. If interest rates across an economy rise by 2%, investors may now want a 7% earnings yield, which means the p/e ratio falls to 14.3 times (1/7%).