What Is the Equity Multiplier?
The term equity multiplier refers to a risk indicator that measures the portion of a company’s assets that is financed by shareholders' equity rather than by debt. The equity multiplier is calculated by dividing a company's total asset value by the total equity held in the company's stock. A high equity multiplier indicates that a company is using a high amount of debt to finance its assets. A low equity multiplier means that the company has less reliance on debt. 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.
Key Takeaways
- An equity multiplier is a measure of the portion of the company’s assets that is financed by stock rather than debt.
- A high equity multiplier generally means that a company has a higher level of debt.
- A lower equity multiplier may indicate that a company is using shareholders' equity to finance its assets or that it cannot attract lenders for a loan.
- Investors judge a company's equity multiplier in the context of its industry and its peers.
- The equity multiplier is also known as the financial leverage ratio.
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Understanding the Equity Multiplier
Investing in new and existing assets is key to running a successful business. Companies finance the acquisition of assets by issuing equity or debt. In some cases, they resort to issuing a combination of both. As an investor, you may want to determine how much shareholders' equity is being used to pay for and finance a company's assets. This is where the equity multiplier comes into play.
As noted above, the equity multiplier is a metric that reveals how much of a company's total assets are financed by shareholders' equity. Essentially, this ratio is a risk indicator used by investors to determine a company's position when it comes to leverage.
A company's equity multiplier is only high or low when compared to historical standards, the averages for the industry, or the company's peers:
- A high equity multiplier indicates that a company is using a large amount of debt to finance its 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 because its debt servicing costs are lower. But it may also send a signal that the company can't entice lenders to loan it money on favorable terms, which is a problem.
Because their assets are generally financed by debt, companies with high equity multipliers may be at risk of default.
Formula for the Equity Multiplier
EquityMultiplier=TotalShareholders’EquityTotalAssetswhere:TotalAssets=Bothcurrentandlong-termassetsTotalShareholders’Equity=Totalassets−totalliabilities
Interpreting the Equity Multiplier
An equity multiplier of two (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, which is 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
- 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 the use of financial leverage. If the equity multiplier fluctuates, it can significantly affect ROE.
Higher financial leverage, such as a higher equity multiple, drives ROE upward as long as all other factors remain equal.
Examples of Equity Multiplier Analysis
The equity multiplier calculation is straightforward. Consider Apple's (AAPL) balance sheet at the end of the 2021 fiscal year. The company's total assets were $351 billion, and the book value of shareholders' equity was $63 billion. The company's equity multiplier was 5.57x (351 ÷ 63).
Now let's compare Apple to Verizon Communications (VZ). The company has a very different business model than Apple. The company's total assets were $366.6 billion for the fiscal year 2021, with $83.2 billion of shareholders' equity. The equity multiplier was thus 4.41x (366.6 ÷ 83.2) based on these values.
Apple's relatively high equity multiplier indicates that the business relies more heavily on financing from debt and other interest-bearing liabilities. Meanwhile, Verizon's telecommunications business model is similar to utility companies, which have stable, predictable cash flows and typically carry high debt levels. Apple is thus more susceptible to changing economic conditions or evolving industry standards than a utility or a traditional telecommunications firm. As a result, Apple carries more financial leverage.
Is a Higher Equity Multiplier Better?
Average equity multipliers vary from industry to industry. In general, investors look for companies with a low equity multiplier because this indicates the company is using more equity and less debt to finance the purchase of assets. Companies that have higher debt burdens could be financially riskier.
What Is a Good Equity Multiplier?
There is no ideal equity multiplier. It will vary by the sector or industry a company operates within. In general, equity multipliers at or below the industry average are considered better.
What Does an Equity Multiplier of 5 Mean?
An equity multiplier of 5.0x would indicate that the value of its assets is five times larger than its equity. In other words, assets are funded 80% by debt and 20% by equity.
What Affects the Equity Multiplier?
A company's equity multiplier varies if the value of its assets changes, and/or if the level of liabilities changes. If assets increase while liabilities decrease, the equity multiplier becomes smaller. That's because it uses less debt and more shareholders' equity to finance its assets.
The Bottom Line
The equity multiplier is a financial ratio that measures how much of a company's assets are financed through stockholders' equity and is calculated by dividing total assets by shareholders' equity.
In general, lower equity multipliers are better for investors, but this can vary between industries and companies with particular industries. In some cases, a low equity multiplier could actually indicate that the company cannot find willing lenders; or it could also signal that a company's growth prospects are low.
On the other hand, a high equity multiplier is not always a sure sign of risk. High leverage can be part of an effective growth strategy, especially if the company is able to borrow more cheaply than its cost of equity.
Correction—Jan. 19, 2023: An earlier version of this article stated that a company's equity multiplier grows larger if its assets increase while its liabilities decrease. This was corrected to show that the reverse is true—that the equity multiplier becomes smaller because it uses less debt to finance its assets.
