How Does The Equity Multiplier Measure Risk Of An Investment?

equity multiplier

Like other financial leverage ratios, the equity multiplier measures asset financing practices. However, this measure offers insight into future earnings.

What Is The Equity Multiplier?

equity multiplier
The Equity Multiplier Is A Leverage Ratio That Measures Financing Leverage

The equity multiplier measures the amount of asset financing attributed to equity. Equity Multiplier = Total Assets / Total Equity. A high equity multiplier infers high debt financing, meaning a relatively low portion of assets financed by equity.

Furthermore, investors use this metric in evaluating investments. Low equity multipliers typically indicate growing or new companies. Conversely, if a new company shows a high equity multiplier, this shows high levels of debt. Overbearing interest payments cause new companies to experience erratic earnings streams. This confuses investors and causes wild stock price moves. Additionally, investors do not understand what the company is worth, causing liquidity concerns.

Equity Multiplier In Practice

This measure is an accounting ratio that measures risk to creditors. Creditors measure risk primarily by liquidity, or ability to repay the loan amount. Savvy investors pay attention to industry trends regarding this leverage ratio. Furthermore, an outlier causes concern to investors. However, this does not mean that company is doomed. Perhaps they have a new business practice that will leave the competition in the dust.

Conversely, perhaps unusual equity multipliers show poor management decisions. Risky capital structure sometimes destroys shareholder value. For example, the equity multiplier is the cornerstone for Dupont Analysis. This analysis, first used by Dupont, suggests that higher equity multipliers yield higher return on equity (ROE) ratios. Some investors use strategies that revolve entirely around this financial ratio, thus seeking companies that fit the mold.

Final Thoughts

Finally, the equity multiplier, like other leverage ratios, need to be compared across industries. It does not make sense to measure a telecom company against a internet security startup. Investors who use factor based analysis, such as investing in companies with high ROE, find this ratio essential in stock selection.

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