Simple Math of Earnings, Multiples & Returns

Professional investors like to throw around fancy words to make themselves feel smart and important.  One of those terms is “Multiple Expansion”.  I figured that 2013 was a great example to illustrate what they mean.

P/E ratio or Price-to-Earnings multiple is probably the most common way to value a stock or a market index.  Let’s take a look at Exhibit 1 and decompose what happened in 2013.  Bear with me here,  The S&P 500 Index closed the year at 1,848.36 up from 1,426.19, so return was (1,848.36 ÷ 1,426.19) – 1 = 29.6%Note: This is the price return which excludes the 2.5% dividend yield.  Operating Earnings grew from 96.82 to 107.07 last year, a jump of 10.6%P/E multiple at the end of 2013 was 1,848.36 ÷ 107.07 = 17.3 times.  This means that the investors were willing to pay 17.3 dollars for each dollar of earnings.  This number went up from 14.7x a year ago – BINGO! – we got MULTIPLE EXPANSION of 17.2%.  Now we can also calculate that multiple expansion accounted for about 62% of the 29.6% return for the year.

Exhibit 1 – Earnings, Multiples and Return Breakdown for 2013


Exhibit 2 shows the same data for each year since 1990. Exhibit 3 displays the middle three columns of this table in a chart format for the more visually-inclined readers.  There are some interesting takeaways from this analysis (at least interesting for a data geek like me).  Earnings tend to increase over the years while P/E multiples tend to jump around a lot.  There were only 5 years out of 24 where earnings decreased year-over-year.  Earnings are typically driven by the business cycle and economic growth, so they closely resemble GDP growth trajectory.  P/E ratios, on the other hand, are largely driven by investor sentiment which is quite fickle.  Investors might be willing to pay 25 times earnings one year and then balk at the 15x multiple the next.

Exhibit 2 – Annual Earnings, Multiples and Returns Since 1990


Exhibit 3 – Annual Earnings, Multiples and Returns Since 1990 – Chart Illustration


Now that we understand how multiples and earnings growth work together to produce price appreciation, we’ll take a look at the longer history of those metrics in a future post.

Data Note

Standard & Poor’s provides free regularly-updated spreadsheets with a wealth of date about the S&P 500 index earnings, dividends, constituent companies, etc.  This detailed information is one of the reasons so many people use the index in their market analysis.   The spreadsheets can be found by going to  Then click on ADDITIONAL INFO dropdown and select “Index Earnings” – this will open an excel spreadsheet with multiple tabs containing variety of earnings data.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s