Understanding the financials of a company is essential to determining whether or not you should buy its stock. When analyzing stock, investors often use the price-to-earnings (P/E) ratio to determine if a stock is cheap or expensive to buy relative to its earnings. Sometimes, this ratio can be negative.
When a company has a negative P/E ratio, it often means it reported negative earnings. However, it doesn’t always mean that it is a bad investment. Understanding how to determine if a company has a negative P/E ratio and why it might have reported no or negative earnings can help you as you expand your investment portfolio.
In this article, we’ll explore what a negative P/E ratio means, the reasons behind it, and how to assess if a stock with a negative P/E ratio could be worth adding to your portfolio.
A negative P/E ratio shows that a company is currently unprofitable.
While it can signal risk, a negative P/E ratio might be acceptable in high-growth industries where profitability takes time.
Carefully assess the company’s financial health, management plans, and industry position before making an investment decision.
Understanding the basics of price-to-earnings (P/E) ratio
The P/E ratio is a straightforward calculation: It is the company’s current stock price divided by its earnings per share (EPS). This metric is popular because it can give investors a quick way to see how much they’re paying for each dollar of earnings.
The formula is:
P/E Ratio = Stock Price / Earnings Per Share (EPS)
When a company is profitable, it has positive earnings, which makes the P/E ratio a positive number. However, if a company has negative earnings (meaning losses), the P/E ratio becomes negative, indicating a negative P/E ratio.
In general, if a company has a high P/E ratio it indicates that the stock valuation is expensive, while a low P/E ratio might mean the stock is cheap. If the P/E ratio is negative, then it often means the company is losing money. Knowing the P/E ratio of company can help you determine the target price of a company.
To understand a negative P/E ratio, it’s important to note that the value of a stock can never be negative. So, a negative P/E ratio only happens when there’s a negative EPS. A company’s earnings might be negative when it either has no earnings during a quarter or reports a loss.
However, most companies will report a negative P/E ratio as an N/A instead of putting a negative value.
Why do some companies have a negative P/E ratio?
Although a P/E ratio indicates a company loss, that doesn’t necessarily mean the company is going bankrupt. There are many reasons a company might have a negative P/E ratio.
1. High start-up costs:
New companies, especially in sectors like technology and biotech, often have high initial expenses before becoming profitable. Companies in growth phases may prioritize expansion and product development over immediate profits.
2. Company is still growing:
If a company is a newer company or going through a growth phase, it may experience a negative P/E ratio. It’s not uncommon for a company to take a few years to see positive earnings, especially in sectors like pharmaceuticals or technology, or for a company to be recently listed on Wall Street as an IPO.
3. Economic downturns:
Broader economic challenges, such as a recession, may impact a company’s revenue and lead to losses. This can cause even established companies to post negative earnings temporarily.
4. Restructuring costs:
Companies undergoing major changessuch as mergers, acquisitions, or operational restructuringmight incur high costs and experience temporary losses.
5. High debt load:
Companies with substantial debt obligations often face high-interest expenses, which can cut into profitability, leading to negative earnings.
6. Emerging industries:
Many companies in new industries, like renewable energy or advanced technology, operate at a loss initially. Investors might look past the lack of profitability, banking on potential growth.
7. Changes to accounting methods:
When a company changes its accounting metrics or policies, the P/E ratio may change. That’s because there are different ways to calculate the EPS, which is what determines the price-to-earnings ratio
8. Changes in depreciation or amortization:
If a company changes its depreciation or amortization policies in a particular year or if there is a market trend, that can cause the company’s P/E ratio to become temporarily negative.
If a company has a negative ratio for a long period of time, such as five years, then investors might want to review its financial statements to see if the company is in good financial health.
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It’s also important to compare the P/E ratio of companies in the same sector, as there may be other factors like stock market conditions or industry-specific conditions that are causing the negative P/E ratio.
Example of a stock that has a negative P/E ratio
To find out if a stock has a negative P/E ratio, you first need to understand how to calculate a P/E ratio.
To determine the ratio, you divide the stock price with the earnings per share (EPS). The formula looks like this:
P/E Ratio = Price Per Share (Market Value) / Earnings Per Share (EPS)
For example, say company ABC has a share price of $50, and its earnings last year were $10 per share. Using the above formula, you would divide 50 by 10 and get the P/E ratio of 5.
Now, lets say a year later, the companys stock price went up to $100, but it reported a negative EPS of minus $10. Then, it would have a negative P/E ratio of -10. If a company has negative earnings, it often means it has losing money over the past 12 months.
However, there could be other reasons that a company was losing money or had a negative P/E ratio. Having a negative P/E ratio doesnt always mean that the stock is a bad investment.
Should you buy stock if it has a negative P/E ratio?
Investing in a stock with a negative P/E ratio is a personal decision based on your financial goals and risk tolerance. Here are a few points to consider:
A negative P/E doesn’t always mean a bad investment
A negative P/E ratio does not necessarily indicate poor valuation or that the company is at risk of going out of business.
Deciding whether to invest in such a stock should be based on how it aligns with your portfolio goals and investment strategy.
Consider your investment goals
For example, if you are looking for growth stocks in anticipation of future earnings, you will likely invest in companies that are just starting out and are likely to have a negative P/E ratio.
But if you want to invest in companies that have a dividend, then buying shares of a company with a negative P/E ratio might not make sense for your portfolio.
There are other financial ratios to consider when investing, such as the forward P/E ratio, the cash flow of a company, its growth ratio, net income, earnings yield, liquidity, and more. Market insights and expert commentary can be helpful. You can find out the financial details of any company on Wall Street with a free brokerage account on Public.
Potential advantages of investing in negative P/E ratio stocks
1. Early investment in high-growth companies:
Investing in companies with a negative P/E ratio during their growth phase may yield significant returns if the company successfully scales and achieves profitability.
2. Lower stock prices:
Stocks with negative earnings often have lower prices, making them accessible to investors seeking potential undervalued assets.
3. Innovative sectors:
Many companies with negative P/E ratios are in innovative sectors such as biotech, green energy, or digital services, offering investors a chance to be part of groundbreaking industries.
Potential risks of investing in negative P/E ratio stocks
1. Financial instability:
A negative P/E ratio often indicates that a company is operating at a loss, which may lead to financial challenges like high debt or the need for additional funding.
2. Market volatility:
Negative earnings can lead to significant price swings, particularly during uncertain economic conditions, making these stocks riskier and potentially more volatile than their profitable counterparts.
3. Uncertain path to profitability:
Not all companies with negative earnings will achieve profitability. Some may continue to incur losses or go bankrupt, leading to potential capital loss for investors.
The bottom line
A negative P/E ratio isnt inherently badits a signal that requires deeper analysis. However, these investments may come with risks, so you can always weigh the potential rewards against the uncertainties.
Every investment decision should align with your financial goals, risk tolerance, and long-term strategy. By staying informed and evaluating companies beyond their P/E ratios, you can make smarter choices in the ever-evolving stock market.
Want to learn more and take your first steps to start investing, download the Public app today! At Public, were serious about support and security. Our US-based, FINRA-licensed team is here when you need them, and your investments are protected with SIPC and FDIC coverage so you can confidently work toward your financial goals.
Frequently asked questions
What does negative P/E ratio mean?
A negative P/E ratio means that the company reported either no earnings per share (EPS) or negative EPS. A negative P/E ratio suggests the company is currently unprofitable, as it has more expenses than revenue. It often means the company made no money over the last 12 months.
What is the ratio of a company’s debt to its equity?
The ratio of a company’s debt to its equity, or D/E ratio, is used to determine its financial leverage. It’s determined by dividing a company’s total liability by its shareholder equity.
What is the formula for a negative P/E ratio?
The formula for a negative P/E ratio is the same as figuring out the P/E ratio of any company: P/E Ratio = Price Per Share (Market Value)/ Earnings Per Share (EPS).
What does negative P/E ratio for ETFs mean?
If a lot of companies have a negative P/E ratio, then it can mean that the ETFs who hold shares of those companies could have a lower or even negative price-to-earnings ratio.
