What Is the Equity Multiplier?
The equity multiplier is a risk indicator that measures the portion of a company’s assets that is financed by stockholder’s equity rather than by debt. It is calculated by dividing a company’s total asset value by its total shareholders’ equity.
Generally, a high equity multiplier indicates that a company is using a high amount of debt to finance assets. A low equity multiplier means that the company has less reliance on debt.
However, a company’s equity multiplier can be seen as high or low only in comparison to historical standards, the averages for the industry, or the company’s peers.
The equity multiplier is also known as the leverage ratio or financial leverage ratio and is one of three ratios used in the DuPont analysis.
Formula and Calculation of the Equity Multiplier
Understanding the Equity Multiplier
Investment in assets is key to running a successful business. Companies finance their acquisition of assets by issuing equity or debt, or some combination of both.
The equity multiplier reveals how much of the total assets are financed by shareholders’ equity. Essentially, this ratio is a risk indicator used by investors to determine how leveraged the company is.
- The equity multiplier is a measure of the portion of the company’s assets that is financed by stock rather than debt.
- Generally, a high equity multiplier indicates that a company has a higher level of debt.
- Investors judge a company’s equity multiplier in the context of its industry and its peers.
A high equity multiplier (relative to historical standards, industry averages, or a company’s peers) indicates that a company is using a large amount of debt to finance assets. Companies with a higher debt burden will have higher debt servicing costs, which means that they will have to generate more cash flow to sustain a healthy business.
A low equity multiplier implies that the company has fewer debt-financed assets. That is usually seen as a positive as its debt servicing costs are lower. But it could also signal that the company is unable to entice lenders to loan it money on favorable terms, which is a problem.
How Investors Interpret the Equity Multiplier
There is no ideal equity multiplier. It will vary by the sector or industry a company operates within.
An equity multiplier of 2 means that half the company’s assets are financed with debt, while the other half is financed with equity.
The equity multiplier is an important factor in DuPont analysis, a method of financial assessment devised by the chemical company for its internal financial review. The DuPont model breaks the calculation of return on equity (ROE) into three ratios: net profit margin (NPM), asset turnover ratio, and the equity multiplier.
If ROE changes over time or diverges from normal levels for the peer group, the DuPont analysis can indicate how much of this is attributable to use of financial leverage. If the equity multiplier fluctuates, it can significantly affect ROE.
Higher financial leverage (i.e. a higher equity multiple) drives ROE upward, all other factors remaining equal.
Examples of Equity Multiplier Analysis
The equity multiplier calculation is straightforward. Consider Apple’s (AAPL) balance sheet at the end of the fiscal year 2019. The company’s total assets were $338.5 billion, and the book value of shareholder equity was $90.5 billion. The company’s equity multiplier was therefore 3.74 ($338.5 billion / $90.5 billion), a bit higher than its equity multiplier for 2018, which was 3.41.
Now compare Apple to Verizon Communications (VZ). The company has a very different business model than Apple. The company’s total assets were $291.7 billion for the fiscal year 2019, with $62.8 billion of shareholder equity. The equity multiplier was 4.64 ($291.7 billion / $62.8 billion), based on these values.
Verizon’s higher equity multiplier indicates that the business relies more heavily on financing from debt and other interest-bearing liabilities. The company’s telecommunications business model is similar to utility companies, which have stable, predictable cash flows and typically carry high debt levels.
On the other hand, Apple is more susceptible to changing economic conditions or evolving industry standards than a utility or a traditional telecommunications firm. As a result, Apple carries less financial leverage. It has a relatively low equity multiplier.
View more information: https://www.investopedia.com/terms/e/equitymultiplier.asp