Is a negative price-to-earnings ratio or negative P/E ratio possible? It is a question that people often ask. The answer is yes. A negative P/E ratio is possible when a company loses money and is reporting negative earnings per share. However, companies don’t report a negative price-to-earnings ratio. Instead, they report “N/A.”
As you know, the P/E ratio is one of the most important indicators to evaluate a company. However, what if your calculations give a negative value? Let’s discuss in detail how it is possible and what it means.
Price to earnings (P/E) ratio
Before understanding how a negative price-to-earnings ratio is possible, it is important to understand the P/E ratio. It is an important indicator when analyzing a company in the market. The P/E ratio refers to the relationship between the price per share and the total income attributed to each share. Most companies report a P/E ratio yearly and it is logically right as well. How so? Because the ratio tells investors how much time the company will take to make its price per share. For example, a company with a price of $100 per share and $10 as earnings attributable per share will take 10 years (100/10).
Furthermore, it is quite simple and straightforward to calculate the P/E ratio of a company. However, the complicated and sophisticated part is its interpretation. There are numerous possibilities. For example, a too-low P/E ratio means the share prices of the company are too low. On the flip side, a too-high ratio means share prices are high while the value for investors is too low. Logically, investors look for a very moderate P/E ratio – one that exhibits reason share price as well as good value for investors.
Negative price-to-earnings ratio
Some people wonder whether a negative price-to-earnings ratio is possible or not. It is very much possible. If you only look at the P/E formula, you will get to know that it is possible. The formula will give a negative value if the numerator or denominator is a negative value. Now, can the share price be negative? No, it isn’t possible. What does that leave behind? It means a negative value of the denominator or earnings attributable to each share will give a negative P/E ratio. Again, the tricky part is how to interpret a negative P/E ratio.
How to interpret a negative P/E ratio?
As mentioned earlier, a negative P/E ratio of a company means the company is reporting losses. For example, a negative price-to-earnings ratio of -10 means that it will take ten years for the company to lose all the equity capital. However, 10 years is a long period and the company may get back on track. Now suppose a company with a -2 P/E ratio. It means the company has only two years to get things right. This is a worrying situation for investors.
Furthermore, does a negative P/E ratio mean the company is in the red zone and can go bankrupt? The answer is no. A negative P/E ratio doesn’t necessarily mean that it is a red flag. This is because a company may have a negative price-to-earnings ratio and still do good because there are different reasons for a negative P/E ratio. For example, a change in accounting policy may lead to a negative P/E ratio. A negative P/E ratio may also be a one-off scenario happening because of cyclical causes. For instance, a company’s higher depreciation for a year may lead to a negative P/E ratio. And in such years, the entire industry may report negative numbers.
In short, such incidents are quite natural during the lifecycle of a company. Therefore, a negative P/E ratio may not be a worrying indicator all the time. However, if a company reports negative numbers for a longer period of time, it should be a point of concern for investors.
Is a negative P/E ratio a negative sign?
As mentioned earlier, a negative price-to-earnings ratio is not always a negative sign. The important thing is how to analyze a company in such circumstances. You can adopt the following strategies to analyze whether the company is struggling or not when reporting a negative P/E ratio.
1. Analyze the history
A negative P/E ratio may be a one-off thing in the company’s history. It is very much possible and it can happen because of various reasons. You can research and analyze the reasons behind the negative value. However, when you look at the company’s history, the picture becomes clear. For example, if the company is reporting a negative P/E ratio consistently, it is a negative sign.
2. Comparison across the industry
Sometimes, almost all companies within a particular industry report a negative price-to-earnings ratio. This may happen because of cyclical causes. Therefore, it is important to compare your company’s figures to other companies in the industry. If all or most companies are reporting negative P/E ratios, this isn’t a negative sign. However, if one company is reporting a P/E ratio of 15 while the other is reporting a negative value, it is a cause for concern. So, you should dive deep to find out the causes of such adverse results and make decisions accordingly.
The P/E ratio is a very important indicator when evaluating a company. However, it is very much possible that your calculations give you a negative value. It may happen. However, this doesn’t necessarily mean that the company is going bankrupt or facing serious financial problems. A negative P/E ratio may be a one-off thing or some cyclical causes made the entire industry report negative values. In fact, there are various possibilities. Therefore, it is important to carefully analyze the situation and make trading decisions accordingly. The best measures are to analyze the company’s history and also compare it with other companies in the industry. Thus, a little research will make the picture clear for you.