For instance, an equity multiple of 2.5x implies that the investor should expect $2.50 for each $1.00 invested in a real estate project. Conceptually, the equity multiple measures the earnings retrieved by an investor relative to the initial investment on a per-dollar basis. The notable drawback to the equity multiple is that the time value of money (or “TVM”), the core premise of the present value (PV) concept, is neglected in the ratio.
However, this strategy exposes the company to the risk of an unexpected drop in profits, which could then make it difficult for the company to repay its debt. An equity multiplier of 5.0x would indicate that the value of its assets is five times larger than its equity. By contrast, a lower multiplier means that the company has less reliance on debt (and reduced default risk). For instance, if a company has an equity multiplier of 2x, the takeaway is that financing is split equally between equity and debt.
Is a high equity multiplier good?
This is important to note that preference shares would not be part of this because of the nature of the fixed obligation. This ratio is useful for all investors as it helps them understand how to calculate equity multiplier a company’s financial leverage. The equity multiplier is an important factor in evaluating a company’s capital structure and is used in the DuPont analysis to calculate return on equity.
- In the formula above, there is a direct relationship between ROE and the equity multiplier.
- On the other hand, a high equity multiplier is not always a sure sign of risk.
- Suppose company ABC has total assets of $10 million and stockholders’ equity of $2 million.
- A company’s equity multiplier varies if the value of its assets changes, and/or if the level of liabilities changes.
- All of these are found on the company’s balance sheet under the “Assets” section.
- Used at the world’s leading real estate private equity firms and academic institutions.
Return on Equity can be calculated by multiplying Profit Margin by Asset Turnover by Equity Multiplier. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.