“Multiple Expansion” — One of Your Best Friends in Microcap Investing
The term “multiple expansion” has a nice ring to it, especially if considering its use from an investment perspective. In fact, each of the term’s two words alone suggest a positive sentiment, what with their respective allusions to growth. Absent any connection to investing, multiple expansion could refer to any number of things, like, say, the growth in belt size many men experience between their 30s and 50s. But what exactly is “multiple expansion” when referenced with investing?
Simply put, multiple expansion refers to the expansion of a stock’s price/earnings ratio based on investor willingness to place more value on the company’s earnings. This willingness, it needs be noted, can drive the stock price up all on its own. Consider the hypothetical J.R. Ewing Gold Company, which trades at $10 per share on a valuation of 10 times its $1 of earnings. Let’s say investor interest starts driving the share price up, and, even lacking any noteworthy news or developments, the stock rises to $25 and pushes the price/earnings ratio up to 25/1. If you’d been invested in the company at $10 per share, multiple expansion helped you more than double your money.
Multiple expansion can also drive markets. Consider the S&P500 during the 1982-2000 bull market, which, at the onset, was trading at a 7X earnings ratio. By the end of the run, the index was trading at a 30X earnings ratio. With a close examination of how much earnings grew during this run, analysts determined that only about 25% of share price gains were due to increased profits, while the other 75% of gains were driven by multiple expansion.
Little doubt that you now recognize how “multiple expansion” can be your friend. Know also that multiple expansion can be an exceptionally good friend to microcap company investors. That said, when picking microcap cap company stocks to buy, the focus should be on potential future earnings growth and other company fundamentals, not multiple expansion. Multiple expansion typically only comes into play when the big boys join the game. And when they do join, you can often witness multiple expansion occurring in real time.
Institutional Investors Drive Smaller Cap Multiple Expansion
Institutions all have rules that dictate what types of equities they are allowed to own and most prohibit investing in companies with market caps below $100 million and many bar the ownership of stocks that trade under $5 per share. This, by the way, helps individual investors by making it easier to pick up potentially great companies at bargain prices. And can help turbo charge stock price gains once the growing company has crossed thresholds that had previously impeded institutional ownership.
Institutional buying tends to create its own momentum. Once a company has crossed the lowest institutional market cap and/or share price thresholds, institutions start to notice. If one likes what it sees about the company, it starts taking a position and often continues to buy in numbers that typically force the share price up. Meanwhile, other institutions take notice, and when the company breaches their market cap and/or share price thresholds, they start to buy, pushing up the share price even higher. And on it goes, with the share price and price per earnings increases driving multiple expansion.
Enter the Indexes
At some point the index funds—in particular for smaller caps, the Russell 2000 and Russell 3000—take notice and, if the company has breached their market cap threshold and meets other parameters, begins taking a position. This typically induces a nice pop in share price on buying day and helps capture even more interest from institutional investors. In fact, many institutions take index positions in order to better help track index performance and have mandates about holding a certain percentage of an index’s positions.
All of this typically adds up to a serious rise in the trading volume of trading and a nice jump in share price through multiple expansion. If your chosen company adds healthy earnings growth to the equation, you’ve won the trifecta with your investment and are enjoying the delights of a multi-bagger.
