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NEGATIVE PE RATIO – What to Do?

I recently received an email from a concerned reader about negative PE ratio. The question looked something like this:

“When P/E is negative then what to do?

Suppose Stock A was:
P/E = -17.65
P/B = 0.35

Suppose Stock B was:
P/E = 9.25
P/B = 4.25

In this circumstance what should I do? Should I buy more shares, sell these shares, or hold these shares?”

First of all, this is a great question because your head is in the right place. You’re starting to get a grip on the importance of valuations, and you’re using multiple valuations to compare stocks with analysis. This is a great stepping stone into solid fundamental analysis.

NEGATIVE PE RATIO

I can’t give you personalized advice, but I’ll share the 3 major possible reasons why a company might have a negative P/E, and then what I do for my own investments in those situations.

To define what a negative P/E ratio implies, we need to refresh our understanding of the P/E ratio. To calculate P/E, simply take price divided by earnings, like this:

P/E = Price to Earnings
       = Price / Earnings
       = Stock Price / EPS

Where EPS stands for Earnings Per Share.

Now, if we look at that formula, we should notice that Price can never be a negative number. Either it’s a positive value, or zero.

So we have to intuitively understand that if a P/E ratio is negative, it only happens because a company has negative EPS, which will also be sourced from negative earnings.

Whether negative earnings is bad, or would cause you to change your investment decision between a buy or a sell is the million dollar question.

In general, there’s going to be three major categories of why a company has negative earnings:

  1. The company is heavily reinvesting for growth and so does not take a profit
  2. The company has run into short term struggles and had either high expenses or low demand
  3. The company’s business is deteriorating and it is a huge red flag on its future

Let’s cover each situation separately.

1—Negative Earnings to Reinvest for Growth

Whether you see negative earnings as a reason to stay away from a stock or inconsequential to your decision making depends on what your investment strategy is.

If you primarily look to invest in growth stocks, then a negative P/E ratio should have little bearing on your decision making.

But it’s important to keep in mind that there’s a big difference between a young growth company which is posting several years of negative earnings and a once profitable company which suddenly turns negative.

With young growth companies, you’ll tend to see negative earnings as they first IPO, and they should have a massive TAM (total addressable market) in order to make their heavy reinvestments an eventual profitable endeavor.

However, this is extremely hard to know ahead of time, which is why many growth investors tend to have very large portfolios with many stocks, since many of those ventures probably won’t succeed.

You have many problems which happen with scale, and so just because a stock has a negative P/E now doesn’t mean they will have positive earnings down the line.

You really have to analyze many other aspects of the business:

  • Where are the losses coming from?
    • Marketing investments, or excessive compensation?
    • More expensive Cost of Goods Sold, or R&D investment?
  • Is the company getting incrementally better or worse with profitability?
  • Is the company taking market share or not?

Many of these questions are very subjective, which can make buying negative P/E ratio stocks very difficult especially when they are young, growth companies.

2—A Company With Temporary Struggles in Profitability

The next situation is another ambiguous scenario, because in answering whether a company’s struggles are short term or longer term in nature, you’re likely to answer the question of whether a buy, sell, or hold was appropriate in that situation.

The reality is that it’s much easier to say whether a company’s struggles were short term or long term with hindsight.

The rearview mirror is always 20-20 in business, and so we should really be careful that we are not overconfident in our analyses of whether a company’s negative earnings are short or long term in nature.

Remember that it’s not about what Wall Street thinks about a company’s situation, but what the business reality actually is.

Wall Street will price stocks a certain way, but eventually those prices will follow the true business fundamentals over the long term.

So you’re going to want to analyze the business, and ask yourself:

Has anything fundamentally changed with the business?

To answer that you’ll have to answer what has caused the company’s profitability to struggle, which takes getting into the numbers, such as the 10-q and 10-k, and looking for discrepancies.

Another resource would be a company’s earnings calls, where management should be able to provide a reason why it has stumbled with profitability.

From there, you should fact check with other sources; if management says it’s an industry-wide problem, check with the recent results of competitors in the same industry. If management says they had one-time expenses, do your due diligence to make sure this isn’t a common thread with the company, and confirm by checking the income statement and notes to the financials.

3—The Company’s Business is Deteriorating

While there aren’t perfect indicators to differentiate whether a company’s struggles indicate a rapidly deteriorating situation or a short-term hiccup, you should be able to make smart guesses based on if you did your due diligence correctly during step 2.

Really you have two options there, and you determine that a company’s struggles are really just temporary then you probably don’t have a deteriorating business.

That said, you have to be on the lookout for secular declines.

The hard reality of capitalism is that there is creative destruction happening all the time.

As new innovations and better customer solutions and services come out, it will be businesses whose old solutions and services can’t keep up which will fall by the wayside.

There are countless examples throughout history of industries that have been wiped out—from the horse and buggy to the printing press to CD manufacturing.

Some companies are able to adapt to secular changes and adapt, leveraging their strong business position and/or balance sheet to innovate and lead a new market or trend. But, many companies don’t, and as an investor it’s your responsibility to make a rational evaluation on how a company is executing on that. This again requires taking emotions out of the picture.

If a company has a negative P/E ratio now, and you find through your analysis that the business or industry is declining from secular trends, this is a surefire indicator to sell!

What Do I Do with a Negative P/E?

For starters, I do not like the uncertainty that comes with young growth companies and so I don’t invest in them whatsoever.

If I invest in a stock which is more “growthy” in nature, you can be sure I’m guaranteeing that the company is profitable and has tangible cash flows, with both of those things poised to continue improving immensely over time.

But I can tell you that when it comes to companies that were once profitable and dip into negative territory, my decision making process is also pretty simple.

Unless I’m upgrading a stock into a “Dividend Fortress” position, I have an automatic rule for my portfolio, which is: sell on negative earnings.

And it’s because history has taught me too many times that negative earnings has been a huge red flag for companies that eventually go bankrupt.

After examining the 30 biggest bankruptcies of the 21st Century, I found that the #1 most common factor for companies in the year before declaring bankruptcy was negative earnings.

It was so pervasive and widespread that it was impossible to ignore.

There are many different metrics within a company’s financial statements, but one of the easiest to look at is earnings, which is what makes the P/E ratio so popular. And yet despite all of this attention on P/E and earnings, you never really hear people talking about the danger of negative earnings.

Negative Earnings and the Business Cycle

With many businesses, they have fixed costs which have to be paid regardless if they can bring in revenues or not.

Whether that’s a retailer needing to pay rent on their property, or a technology firm making huge interest payments on their debt, being in business means taking on certain financial obligations which, if not met, will require an infusion of capital or a default leading to bankruptcy.

During prosperous times in the economy and a bull market, capital usually runs freely and public companies can either borrow additional funds or issue equity to raise them.

But the problem with relying on other sources for funding is that liquidity and access to capital tends to disappear all at the same time, which is when those struggling businesses need it the most.

A retailer with huge fixed costs in a cyclical industry might see their revenues decline precipitously because of reduced demand from customers shifting their spending due to a recession, which is usually the same time that lenders and investors are also tightening their belts.

It’s a vicious reinforcing cycle which is amplified during tough times.

When buying a stock with a negative P/E ratio, you have to consider these factors which play into whether a stock will even recover at all.

Just because a company has a valuable brand or franchise doesn’t mean that the stock will survive—many failing companies will default and then sell their brands or assets after bankruptcy, which does no good to you as an equity investor who gets completely wiped out.

And it all starts with negative earnings, which are generally signaling a difficulty in paying fixed costs.

Remember this judicious quote from Warren Buffett which has undoubtedly played a big part in his success:

We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.

Negative Earnings and Interrupted Compounding

Charlie Munger once uttered a brilliant word of wisdom when he said:

The first rule of compounding: Never interrupt it unnecessarily.

The problem with a company running into negative earnings is that they have to pay for these losses somehow, and it comes either from future or past profits.

If you look at enough businesses over the very long term, you’ll realize that it was the compounding effect of growing earnings which powered the returns for the best stocks in the market as they maintained dominance for decades.

Profitability makes future profitability easier, simply for the fact that a company can reinvest those earnings into more and more avenues of growth.

While you can make the same argument for revenues, you have to wonder what’s the scalability of future profits in a company if they have to scale up expenses just as much as sales in order to grow.

At least when you reinvest through earnings, you’re seeing growth on strength rather than uncertainty.

Having earnings to grow on is a much better guarantee of future growth than a company who may be growing but isn’t profitable yet, and may never be.

When you have a company that is bouncing around between profitability and negative earnings, it’s harder to foresee a future path to sustainable growth, especially if there’s a track record of making cash investments only to have them lead to future losses and repeating the cycle again and again.

I’d highly recommend learning about the insidious nature of goodwill impairments and what they signal about a management’s capital allocation skills in order to really understand how negative earnings interrupt compounding and growth for companies.

Investor Takeaway

When buying a stock with a negative P/E ratio, you can’t get away from these facts about negative earnings.

Even with these lessons, I haven’t done my bankruptcy research enough justice—really you should pick up the Value Trap Indicator book and read about (and see!) the major bankruptcies and the financial numbers which marked distinct warning signs beforehand.

The fact of the matter for you may be that a buy, sell, or hold on a stock with a negative PE is a different independent decision for every single company, but I really hope you don’t take these warnings lightly.

Having rules and boundaries to what you will and won’t accept as an investor is a fantastic way to protect you from being run over in the market.

Don’t justify obviously bad behavior just because you love a company, and take negative earnings seriously.