Equity Multiplier
Candlefocus EditorThe equity multiplier is an important measure of financial leverage used to assess the portion of a company’s assets that are financed through equity or stock rather than debt. Put in other words, it measures the absolute level of risk a company holds in its capital structure. Generally speaking, the higher the equity multiplier, the higher the level of debt burden that the company has and the greater its financial risk. The opposite is true as well: the lower the equity multiplier, the less financial risk the company has on its balance sheet.
The equity multiplier is also known as the financial leverage ratio, which is calculated by dividing total assets by stockholders’ equity. The ratio can range from zero to infinity, but typically a healthy and successful company will have a financial leverage ratio of 2 or higher. This suggests that the company’s assets are being financed with a combination of stocks and debt, which generally increases the return potential as well as the risk of the investment. Investors should bear in mind that a company with a ratio lower than 2 is usually more conservatively funded and may be more desirable from a risk/return perspective.
When investors judge a company’s equity multiplier in the context of its industry and its peers, comparison to the industry average is the traditional way to go, as the general rule of thumb is that the higher the equity multiplier, the lower the quality of financing, and the greater the risk of the investment. Additionally, a company’s publicly traded status can influence the equation as well with regard to equity multiplier — as investors assume that publicly traded stock is of higher quality and thus more valuable.
Essentially, the equity multiplier reflects how much leverage a company has taken, which can drive higher returns if the debt is accurately managed and assumed wisely. It is advisable to look at a company’s recent debt history as well as it's industry mean and peer average before investing. By doing so, investors can make a more informed decision when choosing stocks and better understand the relative degree of risk of their investment.