When looking at stocks, you have probably noticed that some of them have a negative Price-to-Earnings ratio (in some cases it just says N/A, not applicable.) You probably already know that a low P/E ratio means that the stock is cheap, relative to its earnings. If not, now you do.
In this article, we’ll go over what a negative P/E ratio means for a stock, and why it isn’t necessarily a bad thing.
Further down, I’ll give you a real example of a real company with a negative P/E ratio that actually made a lot of money during a period where they reported negative earnings. That might sound impossible, but it’s true, as you will see.
Let’s get started.
A negative P/E ratio means that the company has negative earnings, or is losing money.
When talking about the P/E ratio, it’s generally the trailing P/E. The trailing P/E is uses the EPS (earnings per share) from the last 12 months.
Every quarter doesn’t have to be negative. For the company to have a negative P/E, the last four quarters’ total earnings must be negative.
This means that the company can make a profit in every quarter except one and still end up with a negative P/E ratio if the loss was big enough.
Example. These are the earnings from the last four quarters:
- EPS: $5
- EPS: $5
- EPS: $6
- EPS: -$18
This would result in a negative EPS of -$2 and therefore a negative P/E ratio.
But having a negative P/E ratio doesn’t automatically make it a bad investment. In some cases, it’s even something you can take advantage of, something we will look at further down.
But first, let’s look at two made-up examples of negative P/E ratios, and why they can be so confusing. Don’t worry if you don’t quite understand. This is just to show you why the P/E ratio is a bad metric for companies with negative earnings.
(When it comes to confusing matters, there are often things you can take advantage of by just knowing a little more than the next guy.)
Example of a Negative P/E ratio
Assume that both of the following companies’ shares cost $50 each.
- Company A. reported an EPS of -$0.1. To get the P/E ratio you divide the price ($50) by the EPS (-$0.1) to get a ratio of -500 (note that an earning of -$0.1 per share, is pretty close to breaking even.)
- Company B. reported an EPS of -$30. The price ($50) divided by EPS (-$30) gives a P/E ratio of -1.66. In this case, the company is far from breaking even, but the company’s ratio is not nearly as negative as company A’s.
Confusing, right? Having a high negative ratio is more favorable than having a less negative one, and having a lower positive ratio is more favorable than having a high one.
To make it a little clearer:
- A stock with a P/E ratio of 7 is cheaper than one with a ratio of 70.
- A stock with a negative P/E ratio of -70 is cheaper than one with a ratio of -7.
There’s much more to look at than just the P/E ratio alone, though. You have to look at the reason why the company has a negative P/E ratio.
Why does the stock have a negative P/E ratio?
When looking for stocks to invest in, many investors just take a glance at the P/E ratios, simply ignoring the negative ones. And while it might be a good time-saving method, they miss out on a lot of potentially good stocks.
Other investor’s lack of time, energy, or knowledge is what can create an opening for you to find good but overlooked stocks.
Simply looking at a P/E ratio isn’t enough, especially when it comes to negative ratios. You have to know what caused or causes the negative earnings.
Below is a list of three common reasons for companies to carry a negative P/E ratio.
1. The company isn’t making enough money.
The cost of running the business is higher than what it manages to bring in. If nothing changes, this will inevitably lead to bankruptcy and investors losing their money.
You should look at the company’s financial history. Have they always been losing money? Are they steadily becoming more profitable?
You should also take a look at the growth rate. The company might be unprofitable right now but maybe it’s growing rapidly, making it very likely for it to become profitable in the future.
2. The company might have had a big non-recurring expense.
A non-recurring expense is an extraordinary expense on the income statement not expected to happen again, often something like a write-off.
Analysts usually adjust for these non-recurring expenses, often simply removing them from the calculation.
Depending on the size of the expense, it can hugely impact the reported earnings, and therefore the P/E ratio. But if it’s non-recurring, why should you care?
3. The company carries large non-cash expenses on its income statement.
This one is my favorite. A non-cash expense is an expense that doesn’t involve an actual cash transaction. This means no money is leaving the company, the income statement just makes it look that way. The most common non-cash expenses are depreciation, amortization, and asset write-downs.
The company might have carried non-cash expenses for years, making it look like they’re not making any money and therefore becoming undervalued.
To find out, you have to look at the cash flow statement which only records actual cash transactions, no accounting magic tricks.
Why a negative P/E ratio isn’t necessarily a bad thing
A negative P/E ratio can be a bad thing, but not necessarily. Like we just talked about, it depends.
If the company is constantly losing money, and there doesn’t seem to be a light at the end of the tunnel, then it probably isn’t a good investment.
Some companies make a lot of money without the income statement showing it, though. Those kinds of stocks can make for great investments. Since many retail investors just look at the earnings, they don’t know that the company is actually making money.
Let me give you a real example. If you’re not used to reading financial statements, this might seem advanced, but just hang in there. I’ll try to explain as we go.
This is from the Catena Media annual report from 2019:
Look at exceptional costs, especially at the impairment on intangible assets. That’s a huge cost of $32 million.
An impairment on an intangible asset means that one of the company’s assets was re-evaluated and found to not be worth as much as previously reported.
Since they found the asset to not be worth as much as it used to, they have to adjust the balance sheet and also record the adjustment on the income statement as an impairment charge.
For example, let’s say that the asset was previously valued at $84 million. After the re-evaluation, they found it to be worth $52. They then adjust the item in the balance sheet and charge the income statement the difference, $32 million.
This is a non-cash expense, meaning no cash left the company. It’s just accounting.
As you can see, the result for the period was a loss of $10.35 million before taxes.
(Sidenote: in accounting, a number in parentheses means it’s negative.)
Many investors don’t even get this far, and many of the ones that do, see the loss in the income statement and go: “Yeah… I am not investing in a company not making any money.”
But you and I know better. We know to look in the cash flow statement as well.
At the top of the cash flow statement, you can see the $10.3 loss from the income statement. Below, you will see all the cash from the non-cash expenses added back.
As said before, these items are in the income statement because of accounting rules. No cash actually left the company to pay for these.
With all the cash added back, the company went from -$10.3 million to $45 million before taxes. That’s quite the difference.
Using Price-to-Cash flow (P/CF)
In the case above, the P/E ratio doesn’t make much sense. I would use the P/CF (price-to-cash flow) instead.
To calculate it, you need the share price, operating cash flow, and the number of outstanding shares.
Right before the Coronavirus crash and the company’s annual report, the share price was around $3.87. The company had 58.6 million shares, and an operating cash flow of $38 million.
First, you take the operating cash flow and divide it by the number of shares to get a cash flow per share (CFPS) of $0.65.
Then you take the share price and divide it by the CFPS to get a P/CF of 5.95.
Had you used the P/E ratio you would have taken the share price ($3.87) and divided it by the EPS (-$0.17) and gotten a negative P/E ratio of -22.7.
So should you invest in a stock with a negative P/E ratio?
I think you know the answer by now. It depends on a myriad of factors. But you shouldn’t let a negative ratio automatically stop you from investigating further.
As you now know, negative earnings don’t always mean that the company isn’t making any money.
That’s also why it might be a good idea to actually look at negative PE stocks, specifically. Just to see if something has been overlooked.
I hope you enjoyed the article and learned some new ways to deal with negative P/E ratio stocks.