Understanding Negative PE Ratio Is Good Or Bad: More often than not, investors tend to focus on measures such as consistent profitability, stable revenue streams, dividend-paying capacity, track record of the businesses, etc while investing.
However, it is of utmost importance to understand that a company with such attributes isn’t necessarily a great value pick. Sometimes a stock looks like a good value for long-term investors but it actually is a value trap.
To further filter the research, some investors use valuation measures such as P/E (price-to-earnings ratio), P/B (price-to-book ratio), etc.
The P/E ratio is commonly used by long-term investors. Most investors believe that low P/E means that a stock is undervalued and vice versa.
However, if that’s true, what does a negative P/E ratio exhibit? A negative PE ratio is good or bad depending on several factors such as management quality, future prospects, market share, company size, etc.
In this article, we will try to see whether a negative PE ratio is good or bad and whether or not you should rely only on the P/E ratio while making investment decisions. Read on!
Price-To-Earning (P/E) Ratio – What Is It?
Before looking at whether a negative PE ratio is good or bad, it is very important to understand what is P/E ratio.
The P/E ratio is arrived at when a stock’s current market price is divided by its earnings per share (EPS), usually for the last 12 months—also known as trailing 12 months (TTM).
Most P/E ratios that investors see for publicly-listed stocks represent a stock’s current market price compared with its last 12 months of earnings.
The P/E ratio is one of the most famous valuation ratios which helps us understand if the company is over or undervalued.
Let’s understand this with the help of an example. A stock that trades at INR100 per share with an EPS of INR5 will have a P/E ratio of 20 (INR100 divided by INR5).
Simply put, this means that investors are willing to pay INR20 for each INR1 of earnings.
Trailing twelve months (TTM) P/E is calculated when the current share price of the stock is divided by the last 4 quarterly EPS figures.
This measure can be easily calculated because companies tend to declare financial results (including EPS) on a quarterly basis.
On the contrary, forward P/E is calculated when the current share price is divided by projected EPS over the upcoming 4 quarters. Calculating this measure is a bit difficult in comparison to calculating TTM P/E.
This is because calculating forward P/E needs special skills as it involves forecasting sales, margins, P&L, and EPS.
Analysts and stock market veterans tend to estimate forward earnings and P/E ratios on the basis of guidance given by the company and their own research.
Negative P/E Ratio – What’s Behind It?
The P/E ratio expresses the relationship between the price per equity share and the number of earnings per share. EPS is released by the company every quarter as a regulatory mandate.
If the P/E ratio is negative, then it means that the company is losing money (i.e. it is incurring losses). Knowing the P/E ratio can help investors determine the target price of a company.
To understand the concept of a negative P/E ratio, it is of utmost importance to know that value of a stock can never be negative.
Therefore, a negative P/E ratio exhibits that there are negative EPS. Earnings are negative when the company has no earnings during a particular quarter or it reports a loss.
Negative P/E Ratio – Is It Good Or Bad?
There are several reasons for the company to post negative EPS. Some of them include struggling businesses, difficult market conditions, government policy changes, accounting changes, one-time effects, etc.
Therefore, whether a negative PE ratio is good or bad depends on several factors. Just because a stock has a negative P/E ratio does not mean that the valuation of the company is bad or that company is going out of business.
Whether you should invest in such stock or not is completely an investment decision that you should make on the basis of your portfolio structure.
For example, if you plan to add growth stocks (like technology or biotech stocks) in expectations of future earnings, you will end up investing in companies that have just started and which have a negative P/E ratio.
However, if you want to invest your capital in companies that have a sound and healthy dividend history, then buying shares of companies with a negative P/E ratio might not be a wise decision.
In addition, make sure you do your own research before making investments. Therefore, try analyzing other financial measures including forward P/E ratio, cash flows of a company, growth ratio, earnings yield, etc.
When a company releases its annual results, and its earnings are negative, it is very important to understand the reason behind the negative EPS figure.
There can be a possibility that it is in a growth phase, or it has changed the method of calculating its balance sheet. It doesn’t always mean that there is some major issue with the company.
However, if it continues to report negative earnings year after year, then you might need to consider researching that stock in depth.
Informed investors know that lower or negative P/E is part of the business cycle. Once the market recovers, the company might be in a position to generate healthy profits.
Therefore, whether a negative PE ratio is good or bad should always be ascertained according to the portfolio structure and an investor’s financial goal.
The most important thing to remember while looking at P/E ratios as part of the investment approach is to consider what premium an investor is paying for a company’s earnings today.
Next, it is of utmost importance to assess if expected growth supports that premium. Some investors also compare the subject company’s P/E ratio to its industry peers.
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