A situation in which a publicly-traded company's share price does not rise, or may fall, even on strong earnings. That is, multiple compression occurs when the price-earnings multiple falls. Multiple compression is usually the result of investors' skepticism on growth prospects. Generally, investors buy stocks with high price-earnings ratios if they are confident in high, future growth; when multiple compression occurs, it may indicate that investors believe that growth rates are leveling off, and that the company is unlikely to grow much more. To an extent, this is a positive sign, as it shows confidence that the company has become well-established, but, on the other hand, it may be a sign that investors believe the company's stock is overvalued.
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A decline in a stock's price-earnings ratio in the face of unchanged fundamentals regarding the company. Multiple compression may be caused by a change in investors' view of risk or an increase in market rates of interest. Long-term interest rates and price-earnings ratios tend to move in opposite directions.
Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved. All rights reserved.