The price-to-earnings (PE) ratio is the most commonly used ratio to determine if a stock is cheap or expensive relative to its earnings.
It tells you how many dollars you must pay for each dollar of annual earnings.
Generally speaking, a high PE ratio indicates that a stock is expensive, while a low PE ratio suggests that it is cheap.
However, this changes completely when PE is negative.
A negative PE ratio means that a stock has negative earnings. In other words, the company was losing money in the past 12 months.
The formula for the PE ratio is PE = Stock Price / Earnings Per Share.
If earnings per share (EPS) is lower than zero, then that causes the stock to have a negative PE ratio.
However, earnings per share is sensitive to various accounting methods, so it doesn't always imply that a stock is a bad investment. It depends on many factors.
What a negative PE ratio means for stocks
The stock price can never be negative, so the only mathematical way the P/E ratio can be negative is a negative EPS number.
What a negative EPS means is that the stock had negative net income (net losses) in the trailing twelve months. In other words, adding up the earnings for the past four fiscal quarters results in a negative number.
This does not mean that all the quarters were negative, just that the total number was lower than zero.
For example, if the EPS of the last four quarters was +1, +2, +3, and then -7, that results in EPS of -1 and causes the PE ratio to become negative.
Here are a few reasons why a stock might have negative EPS and a negative PE ratio:
- Struggling business: The company might truly be struggling and is consistently spending more cash than it takes in just to stay afloat. This company has a high chance of bankruptcy and is likely a bad investment.
- Unprofitable growth stock: Many companies with strong revenue growth (like some tech stocks) are unprofitable. But people invest in them because they are growing fast and may become profitable in the future.
- Biotech stocks: It is very common for biotech stocks to have little to no revenue and high expenses. But they may be working on a new drug that will become immensely valuable in the near future.
- Change in accounting: Changes in accounting methods can sometimes cause EPS to go negative for a short period, even if the company didn't lose any money.
- One-time effects: A company may occasionally need to pay a big one-time expense, like a major fine. Or it needs to do a write-down of some major asset. That can cause EPS and PE to go negative temporarily.
Should you buy a stock if it has a negative PE ratio?
You may be wondering whether it is worth investing in a stock with a negative PE ratio.
To get some context, you should check if the company has had losses for a long time or if it just happened recently.
Consistent losses can mean that the company is in trouble. But if it just started losing money recently, then it may be caused by accounting effects or one-time expenses.
It's also helpful to look at other similar companies in the same industry and look at the earnings. If most of the companies have losses, then perhaps the entire industry is in a temporary cyclical downturn.
One good way to see whether negative earnings and negative PE are caused by accounting is to look at the cash flow statement.
This can tell you if the company is actually spending more cash than they take in, or if the negative earnings were due to some accounting rules.
Looking at a company's revenue growth rate and margin trends is also a good idea. Some high-growth companies are investing all their earnings in growing the business but still have a clear "path to profitability" if their plans work out.
However, it can be risky to invest in unprofitable growth companies and biotech stocks. Don't buy stocks in such companies unless you know what you're doing.
To sum up, a negative PE ratio does not necessarily mean that a stock is a bad investment. The PE ratio is just one number out of many, and you need to consider it in context with other metrics and the future prospects of the business.
Why the negative PE ratio is confusing
A negative PE ratio is particularly confusing because the significance of a big and small number is inverted.
In other words, a very negative number is better than a number that's just slightly negative.
Let's imagine two hypothetical stocks that each cost $100 per share.
Company A has an EPS of -$100, which implies massive losses. But company B has an EPS of -$0.01, so it is on the verge of being profitable.
In these cases, company A has a negative PE ratio of $100/-$100 = -1.
But company B, which is on the verge of profitability, has a "sky-high" negative PE ratio of $100/-$0.01 = -10,000.
In this case, the bigger negative number is actually the better one. It means that the company's losses are minimal.
This is the opposite of a positive PE ratio, where a smaller number is generally seen as a good thing, while a bigger number implies that the stock is more expensive.
Most financial sites show "n/a" if PE is negative
Most good financial information websites (including Stock Analysis) don't even show the PE ratio if it's negative.
Instead, they show "n/a" (not applicable) or a dash where the PE ratio is supposed to be. This is because a negative PE ratio is confusing and not very informative.
Finance and stock information websites will show you if a stock is unprofitable in other ways, such as by showing a negative net income or EPS number.