What Does a Negative P/E Ratio Mean and Should You Invest?

It’s sometimes tricky to decide which stocks to invest in. Financial metrics like a company’s P/E ratio can help determine whether a stock is worth buying. But what happens when you come across a stock with a negative price-to-earnings (P/E) ratio? Is it a red flag you should run away from, or does it mean you need to investigate more to see if you need to look beyond the stock valuation?

Keep reading as we take a closer look at what a negative P/E ratio means and determine whether these stocks are worth purchasing. 

Pro Tip: Utilizing Ziggma’s investment tracker will allow you to understand the P/E ratio for companies in your portfolio. This information will allow you to make smart financial choices.

Understanding Price-to-Earnings (P/E) Ratio

The price-to-earnings (P/E) ratio helps investors understand if a company’s stock price is expensive or cheap compared to its earnings. The P/E ratio is calculated using the following formula:

P/E Ratio = Stock price/ Earnings per share (EPS)

When calculating EPS for this formula, a company can use its past twelve-month performance (trailing P/E) or an estimation of what the company expects to earn in the future (forward P/E).

Analysts use a stock’s P/E ratio to assess valuation. A stock with a higher P/E is typically more expensive since investors pay more for each dollar of the company’s earnings. This usually indicates an overvalued stock. Conversely, a stock with a lower P/E ratio may indicate it is undervalued compared to its competitors. 

As with any financial analysis, you shouldn’t exclusively evaluate a stock’s P/E ratio in a bubble. Compare it to the stock’s past performance, other stocks in the industry, or the market to better gauge its relative valuation before making a judgment. 

Also Read: Investment Terms To Know

What Does a Negative P/E Ratio Mean?

A company’s stock price can’t go negative, which means the only way to calculate a negative P/E ratio is to have a negative EPS. Typically, a negative EPS implies the company is reporting a loss for the previous twelve months. 

Companies report losses for various reasons, so a negative P/E ratio doesn’t necessarily indicate a bad investment. While a consistently negative P/E ratio may signal impending bankruptcy, some periodically have negative EPS due to factors unrelated to a company’s financial health.

Also Read: Investing in a Stock Market Correction

What Can Cause a Negative P/E Ratio?

While a negative P/E ratio typically indicates that a company is unprofitable, you may need to do some detective work to understand the underlying causes.

Struggling Businesses

Struggling businesses spend more than they earn, which makes them unprofitable. Businesses struggle for different reasons, like financial mismanagement, inadequate marketing, or poor planning. Whatever the reason, it may be a red flag for investors if it’s causing the company’s negative P/E ratio.

One-off Expenses

Sometimes, a company has a large one-off expense that has resulted in a temporary loss for the past twelve months. Some significant one-time expenses include legal payouts, fines, restructuring costs, or environmental disaster losses.

A sizeable one-time expense resulting in negative earnings isn’t as serious a warning sign as a struggling business consistently reporting losses. In this scenario, a company’s stock can potentially make for a good investment.

Also Read: Bid vs. Ask Price: What’s The Difference?

Changes in Accounting

A company’s EPS is calculated differently depending on the accounting method used. If a company changes its accounting method, the EPS may go negative, resulting in a negative P/E ratio. This cause for a negative P/E ratio alone is not an outright red flag to not invest in the stock, so you may need to do more research to see if the stock is a wise investment.

The Company is in High-Growth Mode

Getting a business off the ground takes time and money, and many startups and high growth companies spend heavily on research and development or invest in infrastructure. It’s relatively common for companies to operate with losses for the first few years while they grow.

A business in high growth mode may have a negative P/E ratio now but be a lucrative stock in a few years. You should evaluate the company’s strategic plan for growth to see if it is likely that they achieve profitability.

Restructuring Costs

Sometimes, companies merge or acquire other companies or restructure their internal operations. The costs of restructuring may cause the company to report a loss. However, if the restructuring is successful, the P/E ratio can reverse, and the stock may be worth investing in.

Also Read: Apps That Give You Free Stocks

Should You Invest in Companies with a Negative P/E Ratio?

A negative P/E ratio is not always a sign that you shouldn’t invest in a stock. After some detective work, you may find the company’s losses aren’t a result of financial struggles or a sign of a potential bankruptcy. Instead, additional context may show the company is growing, restructuring, or recognizing a significant one-time expense.

These aren’t immediate causes for concern, but you may need to do additional research to determine whether the stock is worth investing in.

Before making a decision, look into the company’s P/E ratio over the past five years. If it’s been negative the entire time, the company may be struggling and not make a good investment. If the losses are more recent or the company is just starting, you should do more research before purchasing the stock.

The Bottom Line

Don’t immediately run from a stock with a negative P/E ratio—it does not always indicate a bad investment. Remember, the P/E ratio is just one metric. With any investment decision, do your research and consider the context before making a purchase. A negative P/E ratio today, might not indicate poor future earnings.

Frequently Asked Questions

What does it mean if the PE ratio is negative?

Having a negative P/E ratio means the company’s earnings are negative during the previous 12 months. In other words, the company is spending more than it earns in revenue. This can be caused by several different reasons, including:

• They’re going through a period of financial distress.
• The company is restructuring or going through a turnaround.
• They’re a high-growth company that wants to prioritize expansion instead of profits.
• They had a significant one-time expense on the books.

What is a good PE ratio?

A good P/E ratio depends on several factors, including the industry, current market conditions, and the company’s growth outlook. To understand if a company has a good P/E ratio, it’s important to compare it to other companies in their industry.

Is 0 PE ratio good?

It’s not possible to have a 0 P/E ratio. P/E ratios must be either positive or negative. A company with no earnings would have an undefined P/E ratio.