In one line
The price/earnings (P/E) multiple is the share price divided by a year's earnings per share. Results are judged against consensus, the profit analysts expected: above it is a beat, below it a miss.
What it does
- A company is worth its future profits in today's money. Faster growth raises the multiple; higher interest rates lower it, because future profit is worth less today.
- In Countermove the fair multiple is (1 + 1.5 × growth) divided by the interest rate plus a 4.5% equity risk premium, held between 8 and 30. With no growth and rates at 2.5%, that is about 14 times earnings.
- Each quarter the price moves part of the way towards fair value, and reacts to the surprise against consensus: 5.5% per unit of surprise, capped at 6% either way.
- Analysts set next quarter's consensus from the same quarter last year and the trend, so a quarter flattered today raises the bar for the same quarter next year.
Business and brand
Impact on the businessP&L, cash, share price
- Cutting brand media makes this quarter's number and costs sales in the quarters after.
- Loading stock into retailers books sales early; analysts mark down earnings they think won't repeat, and the next quarter misses.
- A rising share price makes it cheaper to raise money and keeps the board on side.
Impact on the brandMemory, loyalty, pricing power
- Brand building is a cost now and a return later, so short-term pressure falls on it first.
- A brand that keeps its media through a tough quarter keeps its memory, and its future sales.
- Steady, repeatable growth is what earns a higher multiple.
Try it
Make the number, or not
First see how growth and interest rates set the multiple. Then make one quarter's number by cutting brand media or loading stock into retailers, and follow the share price for two years against the plan.
The share price of Brightwater's company at the end of each quarter. The line marks the quarter you made the number.
| Quarter | Earnings | Consensus | Price reaction |
|---|---|---|---|
| Q1 | €0.31 | €0.24 | ▲ 1.5% beat |
| Q2 | €0.21 | €0.21 | ▲ 0.0% in line |
| Q3 | −€0.02 | −€0.07 | ▲ 1.7% beat |
| Q4 | €0.19 | €0.15 | ▲ 1.1% beat |
The reaction is 5.5% of price per unit of surprise (the gap to consensus over a normal quarter's earnings), capped at 6%. The price also closes a fifth of its gap to fair value each quarter.
Notice: Q1 earnings €0.31 a share against €0.24 expected. The price is ▲ 1.5% against the plan that quarter. Sales lost to the cut show up in the quarters after. Two years on, the price is ▼ 3.4% against the plan.
Runs Countermove's market engine: the reference soft-drinks market, three brands, rivals holding their plans so only your change moves the result.
Sources
- Damodaran (2012), Investment Valuation, 3rd edition, Wiley: multiples, growth and the cost of equity
- Ball & Brown (1968), Journal of Accounting Research: an empirical evaluation of accounting income numbers
- Graham, Harvey & Rajgopal (2005), Journal of Accounting and Economics: the economic implications of corporate financial reporting