The P/E ratio shows the market value of a stock compared to the company's earnings. The P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. It is possible for a stock to have a negative price-to-earnings ratio (P/E).
A high P/E typically means a stock's price is high relative to earnings while a low P/E indicates a stock's price is low compared to earnings. The P/E is calculated by dividing the current price by the current earnings per share or EPS.
What Does the Price-to-Earnings (P/E) Ratio Indicate?
Investors use the P/E ratio to determine if a stock is overvalued or undervalued. However, investors also use the P/E to gauge market expectations for future earnings growth. A high P/E might indicate that investors expect earnings growth in the coming quarters and, as a result, investors have been buying the stock in anticipation of its appreciation.
A negative P/E ratio means the company has negative earnings or is losing money. Even the most established companies experience down periods, which may be due to environmental factors that are out of the company's control. However, companies that consistently show a negative P/E ratio are not generating sufficient profit and run the risk of bankruptcy.
A negative P/E may not be reported. Instead, the EPS might be reported as "not applicable" for quarters in which a company reported a loss. Investors buying stock in a company with a negative P/E should be aware that they are buying shares of an unprofitable company and be mindful of the associated risks.
Under What Circumstances Would a Company Have a Negative Price-to-Earnings (P/E) Ratio?
While a negative P/E ratio indicates a company is reporting losses, this is not always a sign of impending bankruptcy. A company might have a negative P/E ratio yet be on a path to growth. I a company changes its accounting systems or policies, that might change the P/E ratio. Similarly, changes in depreciation or amortization policies in a particular year or a market trend might cause companies to report a negative P/E ratio temporarily.
An investor should become alarmed if a company consistently shows a negative P/E ratio for a long period, for example, five years in a row. If this is the case, the company is not in good financial health.
When Is a Negative P/E Less of a Concern?
In some sectors, it is not uncommon for companies to show negative P/Es when they are newly launched. Pharmaceutical companies that invest billions of dollars in drug research may report a loss for years before turning a profit. Also, technology companies may post a loss initially, yet the stock price may rise significantly due to market expectations of positive earnings growth in the coming years. As with any financial metric, it's important to compare the P/E ratio with the P/E ratios of other companies in the same industry.