Not every company is able to generate profits, some of them actually lose money. Price-to-earnings commonly referred to as the P/E ratio is a useful measure of the company's valuation, based on its earnings. How do you calculate the price-to-earnings ratio of a company that loses money? Well, that stock will have a negative P/E ratio. A negative P/E ratio simply means that the company has negative earnings or losses.
What is a negative P/E ratio?
Price-to-earnings is calculated based on the stock price divided by its earnings per share. Since a stock price is always a positive number, the only way for a stock to have a negative P/E ratio is if the earnings are negative. In essence, that means that the company is losing money.
In the same way, investors use a price-to-earnings ratio to assess a company’s valuation, they can use negative P/E. The negative P/E will simply represent how many years it will take before the company loses its initial investment. The more years it takes the closer the company is to profitability. So in essence the lower the negative price-to-earnings ratio, the closer the company is to breakeven. This is a particularly useful metric, to analyze fast-growing companies.
How does a negative P/E ratio work?
Some financial data providers often do not show negative P/E ratios. This is because it can generate misunderstandings. To understand this concept better let’s look at an example:
Stock A is trading at $10, and its EPS is $1. This means that the P/E ratio will be 10.
Now let's look at another example of a company that is losing money.
Stock B is trading at $10, and it has -$1 EPS. In turn, the stock has a P/E ratio of ~10.
Let’s say that stock B improves its results and now has -$0.5 in EPS. That means that its P/E ratio went from -10 to -20.
So when a company reduces its losses, the price-to-earnings ratio will decline until the breakeven level of zero. This is why most financial data providers will seldomly show the negative P/E because it can be confusing. The less money a stock loses, the lower its negative P/E ratio will be. The lower the negative P/E ratio, the less money the company is losing, and the closer it is to reaching profitability.
How common is a negative P/E ratio?
Some financial data providers often do not show negative P/E ratios. This is because it can be misunderstood. Negative P/E ratios are especially common across high-growth companies, and sectors. Sectors like technology, and biotechnology where companies have to spend a considerable amount of money to develop their products and services. Sectors or companies that are highly dependent on high R&D spending, or capex are also prone to having losses.
High-growth companies tend to sacrifice profitability in the early years, in order to achieve higher revenues. Because of this, it is particularly common also among startups.
Why do stocks have negative P/E ratios?
There are several reasons that might explain why a company has a negative P/E ratio and is losing money. There are some sectors where losses are common among companies, and that should also be kept in mind. However, there are a few key reasons that tend to be common among certain stocks.
Flawed business model
A flawed business model can impact a company’s profitability. A company with a flawed business model means that it is constantly losing market share to its competitors, and it is bound to fail. This is perhaps the biggest risk with a negative P/E ratio, and you might want to avoid these stocks.
Some stocks in declining sectors are also known for having a negative P/E ratio. Companies in industries that are struggling will often have losses. It is therefore common for these stocks to have a negative P/E ratio.
The fast-paced world we live in today is constantly changing. Companies and sectors that are trying to adapt to recent changes in their business environment will often lose money. This happens because there are investments that need to be made. There are also product and service offerings that need to be revised.
Negative P/E ratios are most commonly found among high-growth stocks. These companies will usually sacrifice their bottom line to improve their top line. In essence to increase revenues, and acquire more customers, management will often put more emphasis on revenue growth. In the short-term losses might be expected for these companies. If it is a high-quality growth company, it will eventually reach profitability.
Impairments can happen for a number of reasons, but they are often associated with a decline in a company’s asset value. This decline will often mean that a particular asset the company holds, is no longer as valuable as it was accounted for. In turn, companies that have impairments in a particular time frame might lose money. This will push the stock to have a negative price-to-earnings ratio.
Companies will use different accounting methods, and this can also influence their results. When a company changes its accounting method, it might influence its earnings. Based on this new method, the company might have a loss. The stock can temporarily have a negative price-to-earnings ratio.
Companies and sectors often have setbacks. These setbacks can happen for a number of reasons, and they might influence earnings. With that in mind, a temporary setback might push a company to lose money in a certain time period. If it happens the stock will have a negative P/E ratio.
Some stocks due to the nature of their business are highly cyclical. This in turn means that the company might lose money during a certain period of time. During that period, the stock has a negative P/E ratio, representing the negative earnings of the period.
There are also companies whose results are highly driven by seasonal factors. This means that during short periods of time, the company might have losses. For that reason, these seasonal stocks might have a negative P/E ratio.
Lack of investments
Competition across sectors and industries is fierce. A company that has negative earnings might signal that it is not investing properly, or its return on investments is low. This can be a warning signal for investors in the stock and can push its P/E ratio into negative territory.
A high-quality management team will make sure that the company is consistently profitable. Losses can sometimes be attributed to a lack of oversight by some management teams. This could push the company to lose money.
Another factor that can highly influence profitability, and earnings are costs. Costs may go up for a number of reasons, and they can have a direct impact on the company’s profitability. It is important to know that a stock can have a negative P/E ratio due to higher costs that push the company to lose money.
How to use a negative P/E ratio?
A negative P/E ratio allows investors to forecast how many years it will take before the company loses the equivalent of its initial investment. It can also be extremely useful when analyzing the company’s performance historically. Comparing the negative P/E overtime might give an accurate idea of how the company is doing.
A company that has a negative P/E ratio but it is reducing its losses, might signal that it is about to reach profitability. This means that the lower the negative P/E ratio the less money a company is losing, on a per-share basis. It can also be used to avoid certain stocks, whose losses tend to increase over time.
When it comes to the negative P/E ratio it is mandatory that as an investor, you understand what is the reason behind the losses. This is the key aspect to investing in unprofitable companies. There needs to be a clear path to profitability so that your investment is worthwhile.
Is a negative P/E ratio good or bad?
Well, the negative P/E ratio on its own does not mean much. Other than the fact that the company is losing money, you cannot really understand much more by just looking at this particular ratio. In more established companies, it can be a sign that for some reason changes need to be implemented.
For relatively new companies, it is a common trait. It just means that the company is channeling its capital towards growth. In a broader sense, a negative price-to-earnings ratio is bad because it shows that the company is losing money. Every company is different and for that reason, without thoroughly analyzing each company, you cannot draw any conclusions from a negative P/E ratio.
Buying stocks with a negative P/E ratio
The negative P/E ratio is as useful as a positive P/E ratio, but it is important to fully understand the concept. For investors looking for companies with negative P/E ratios, it is important to put things into a historical perspective. Analyzing how the company is improving its results, and reducing its losses is a key step to investing in distressed, or high-growth stocks.
As an investor, you want to make sure that the stocks you invest in will be able to generate a profit in the future. With that in mind, you want to make sure that the stock you are investing in, clearly has a path to profitability. Making sure that you only invest in negative price-to-earnings stocks that will become profitable is the key.
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