Price to Earnings Ratio is a very important metric that is used by investors in order to gauge the viability of a particular stock. This particular stock draws a comparison between the price of the particular share and the earnings that the company has reported over the course of time.
This ratio is basically a representation regarding what the market is ready to pay current for the listed stock based on its earnings. These earnings can be both, past and forward PE.
In the case where past earnings are utilized to calculate the PE Ratio, it is referred to as a trailing PE Ratio. On the other hand, if the future estimates and approximations are used in order to calculate the future earnings, it is referred to as a forward PE Ratio.
From the investors’ perspective, it can be seen that investors mostly require and go for shares that have a higher PE Ratio.
This is mainly because of the fact that it shows that the given stock or share has a potential to earn a substantial amount of money in comparison to other stocks with relatively lower PE Ratios.
Hence, this particular metric is highly resourceful because it helps to draw a comparison between different stocks pertaining to their ability to generate profits.
PE Ratios are mostly positive. Positive PE Ratios are indicative of the fact that the company is making profits, and is sustaining itself.
However, in the case where the company is making a loss, or is unable to make decent profits, it can be seen that PE Ratio can also be negative.
It must be noted that there are very cases where companies report negative PE Ratios, because it is not beneficial for them to report them otherwise.
Price to Earnings Ratio is a comparison of the existing price of the stock, relative to the overall earnings it is generating. Therefore, it is calculated using the following formula:
PE Ratio = (Price of the stock) / (Total Earnings of the company or Earnings per Share)
Reasons for negative P/E Ratio:
Despite the fact that in most cases, companies have positive PE Ratios, it can be seen that there are a few instances where the company might end up having negative PE Ratios.
It is mainly because of the fact that the company has reported negative earnings over the recent past, because of which the PE Ratio turns out to be negative. The main reasons for a negative PE Ratio are as following:
- Company incurring a loss over the course of time – this means that the company has not reported profits over the recent past, because of which the denominator is negative. This would automatically make the PE Ratio negative.
- New projects: In the case of new projects, companies often have negative PE Ratios because they are in the initial phases, and they have not begun generating revenues as yet. This is often the case for newly established businesses, who are incurring initial setup costs as a result of new projects being set up.
- In the same manner, it can also be seen that negative PE Ratios often occur because of unprecedented circumstances and situations. A company suffering an unprecedented loss, or an uncalled for expense might be the reason behind the negative PE Ratio.
Implications for Negative PE Ratio:
A negative PE Ratio can often be a cause of an alarm for investors. It might hint that the company is no longer doing well, and might declare bankruptcy in the coming future.
However, it must be seen that a negative PE Ratio that persists across the company’s balance sheet is often a cause of concern for the investors.
On the other hand, if the negative PE Ratio is temporary, and occurs as a one off incident, is not always necessarily a bad thing. Here are a few reasons as to why negative PE Ratio is not always bad:
- A negative PE Ratio that occurs because of a one-off incident, like an unprecedented loss or litigation will reduce the earnings for that particular year only. In this case, it is better to realize the fact that negative PE Ratios for that particular year can be relevant to that particular year only. Therefore, it might helpful for investors to consider past (trailing) PE Ratios to get a better idea about the company.
- Negative PE Ratios that happen because of the investment in numerous different resources and projects might mean that there are better growth prospects for the company in the future, which are currently unaccounted for. Hence, negative PE Ratios in individuality might not be an accurate representation of the organization’s position.