A negative price-to-earnings (P/E) ratio occurs when a company either makes a loss or does not report earnings for the year. However, it’s rare to see a negative price-to-earnings (P/E) ratio on a company report. Not because it never happens – of course, some businesses lose money – but because it’s reported as “0” or “N/A”.
Part of this is to hide how much money the company has lost that year, but part of it is because a negative P/E ratio can mean different things. Unfortunately, it’s not as simple as saying, “the company is not a good investment because it has a negative P/E ratio”. There’s more to the story.
Its interpretation depends on various factors involved with the business itself and its industry, which is why understanding what it means can be incredibly confusing.
To clarify some of the mystery behind a negative P/E ratio, this article will cover exactly what a negative P/E ratio can mean, how to interpret it depending on the situation, and more.
What does a negative P/E ratio mean?
Whilst a negative P/E ratio can mean that the company is struggling financially and is losing money, this isn’t always the case. A negative P/E ratio could just mean that a company:
- Is new and is not yet profitable due to high investment costs, but it is growing exponentially and will be profitable in the future
- Has changed its accounting methods
- Had a big one-off expense, such as a downpayment for a new facility, that has eaten into its profits and revenue
- Invested heavily in research which can pay off in the future – commonly seen in the pharmaceutical industry
A prime example of this is Tesla. Tesla has had a negative P/E ratio for years because it had been operating at a loss. It would be a mistake to say that Tesla is not a worthwhile investment just because they haven’t made a profit.
Taking a long-term view, analysing the industry, and the company itself would indicate that it’s just a matter of time before they begin to make money. This is why a negative P/E ratio can be difficult to understand, but before we delve further into that, let’s take a step back and look at what a P/E ratio represents.
What is the price-to-earnings (P/E) ratio?
The price-to-earnings ratio – also known as the price-earnings ratio or P/E ratio – is the market value of a company’s stock price compared to its earnings per share (EPS). In other words, it shows the price of a stock compared to the company’s earnings or profit.
A high P/E ratio means that the stock price of a particular company is high compared to its earnings, i.e. it is expensive. A low P/E ratio means that the stock price of a particular company is low relative to its earnings, i.e., cheap.
Comparing a company’s current earnings does not paint the full picture of its performance. That’s why investors use the P/E ratio to analyse the value of a company’s shares compared to its competitors in the same industry. This can help determine whether it is overvalued or undervalued.
How to calculate the P/E ratio?
A company’s P/E ratio is calculated by dividing its current stock price by its earnings per share. The ‘P’ stands for current stock price, and the ‘E’ stands for the company’s earnings per share.
To calculate a company’s earnings per share, you first have to look at its profits and the number of shares issued in the stock market.
Suppose a company has made £300,000 in profit this year and has issued 50,000 shares in the market. The company’s EPS is £6 (£300,000 / 50,000 shares).
The current stock price of the company is valued at £48. This means that their P/E ratio is 8 (£48 / £6).
Calculating the P/E ratio of a company is easy. The hard part comes when trying to interpret what it means.
How to compare companies using the P/E ratio
P/E ratio by itself does not provide helpful information. It’s only useful when the P/E ratio compares two or more businesses in the same industry.
Suppose two companies sell swimming trunks. Company A is trading at £50 per share, whereas Company B is trading at £5 per share. You may think that the shares of Company B provide the best value for money since it is cheaper, but this isn’t always so black and white. Therefore, to help compare these two companies more accurately, the price-to-earnings ratio is used.
Company A makes £1 million in profit per year and has issued 100,000 shares in the stock market. This means that Company A’s earnings per share is £10 (£1 million / 100,000 shares). At a share price of £50, Company A has a P/E ratio of 5 (£50 / £10) – the stock is trading at 5 times its earnings.
On the other hand, Company B only makes £200,000 in profit per year. They, too, have issued 100,000 shares in the stock market. As a result, Company B’s earnings per share is £2 (£200,000 / 100,000 shares). At a share price of £5, Company B has a P/E ratio of 2.5 (£5 / £2) – the stock is trading at 2.5 times its earnings.
On the surface, it may seem that Company B is better value for money since an investor will pay less money per £ of earnings. However, you also have to consider other factors, such as future earnings.
Suppose Company A has just released a new fast-drying swimming trunk, and the patented technology used to make the material is groundbreaking.
Here is where future earnings come in. Company A has the potential for higher earnings growth compared to Company B due to its innovation. Thus, its stock price has risen, which, compared to its current earnings, can seem high or expensive.
A high P/E ratio is considered a good thing in this particular scenario. It shows that the company’s earnings are expected to increase over the next few quarters, and this assumption of growth is driving the high P/E ratio.
In general, investors must analyse numerous other factors to determine whether the company’s high or low P/E ratio is considered positive or not.
How to interpret a high P/E ratio?
Investors expect an increase in future earnings
One could argue that a high P/E ratio is a good thing because there must be a reason why investors are willing to buy shares in the company even though the stock prices are so high.
As we’ve seen in an example earlier, this could be because investors expect the company’s future earnings to grow significantly. This would make the current share price “worth it”.
Stock may be overvalued
On the flip side, you could also argue that the high P/E ratio shows the company is overvalued. Compared to its negative earnings, the price of shares is too expensive and is considered a bad investment. This is particularly relevant when similar companies in the entire industry all have a low P/E ratio.
Additional analysis must be conducted to determine the cause of a high P/E ratio. Is the P/E ratio higher because of market hype and market trend? Or is the ‘expensive’ stock price due to an innovation or company change that has improved its future earning prospects?
How to interpret a low P/E ratio?
Company earnings have dropped
Much like how a high P/E ratio can represent investors’ faith in a company’s future earnings, a low P/E ratio can represent investors’ pessimism about the company’s future.
Stock may be undervalued
In a situation where a company’s earnings have increased but its stock price has remained the same, its P/E ratio will be lower. Investors will view this as the company’s stock being undervalued.
Since the company’s stock price does not reflect the value of its earnings, this can present a great opportunity for investors. They will want to get ‘ahead’ whilst the stock price is low with the hopes that in the future, the stock price will increase in line with its earnings.
In any case, further analysis must be done to assess why the P/E ratio is low. You should ask similar questions as when assessing a high P/E ratio, which will determine whether a share should be bought, sold, or held.
How to interpret a negative P/E ratio?
To interpret a negative P/E ratio, you must first get context on the company and its industry.
Assess the historical P/E ratio of the company
If a company has only shown a negative P/E ratio in the last year or two, this could be due to changes in accounting methods. It could also be due to a big expense that has impacted its earnings. In these cases, a negative P/E ratio can be seen as a one-off.
But, suppose a company has consistently shown losses for the past five years. In that case, it could indicate that it is financially struggling and is having a downfall.
You can look at the cash flow statements to obtain a clearer picture. Are they re-investing their profits and earnings back into the company on research and development? Have they adopted a new aggressive marketing strategy? Have they undergone a structural change within the company?
These are all questions you should be asking to anticipate whether the negative P/E ratio will remain as such or whether it is temporary and is expected to become positive in the future.
Compare P/E ratio to its competitors
If a company has a negative P/E ratio, but its competitors have positive ones, this could be a red flag. On the other hand, if its competitors are also showing losses, this can indicate a cyclical downturn in the entire industry. As a result, it may be the case that the company will have to ride out the storm.
It’s also important to consider the industry that the company is in. It’s not uncommon for technology and pharmaceutical companies to invest large amounts of money in research and building for a few years.
During this time, many, if not all, will show a negative P/E ratio. However, the stock price of these companies can remain high since investors expect their future earnings to increase drastically in the coming years.
Final thoughts
As you can see, the meaning of a negative P/E ratio will differ depending on the company’s circumstances. Context matters and further analysis of the company and its industry will determine whether the negative P/E ratio is something to worry about or not.
Therefore, an investor should look at more than a company’s P/E ratio to determine whether to buy, sell, or hold an investment.