Multiple compression

Multiple compression is when company's price/earnings multiple falls as investors become wary of a company's growth prospects. The share price may be static or falling, despite increasing earnings.

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%).

Most Popular

Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022
Temple Bar’s Ian Lance and Nick Purves: the essence of value investing
Investment strategy

Temple Bar’s Ian Lance and Nick Purves: the essence of value investing

Ian Lance and Nick Purves of the Temple Bar investment trust explain the essence of “value investing” – buying something for less than its intrinsic v…
14 Jan 2022
US inflation is at its highest since 1982. Why aren’t markets panicking?
Inflation

US inflation is at its highest since 1982. Why aren’t markets panicking?

US inflation is at 7% – the last time it was this high interest rates were at 14%. But instead of panicking, markets just shrugged. John Stepek explai…
13 Jan 2022