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.
Before I answer your question, I have to provide the caveat that I can’t give you personal advice on your investing decisions. It’s against the law. So if these are actual stocks that you may own, I can’t tell you what to do and you’ll have to use your own judgment. However, I can tell you what I would do in that kind of a situation and hopefully through this process you’ll glean some helpful information.
Now, when it comes to buying stocks I hold firm with 3 unbreakable rules, as found in 7 Steps to Understanding the Stock Market. Those 3 rules are the following:
1. Never buy a stock with negative earnings
2. Never buy a stock with negative shareholder’s equity
3. Don’t buy a stock that doesn’t pay a dividend
Right away you should notice that negative earnings is a big warning sign in individual stocks. (I’m referring to negative yearly earnings). If a company can’t perform its main function, which is to create profits, then this is a problem and the company shouldn’t be touched.
I’m sure you’ve heard of stories of companies recovering from tough times and soaring to new heights after previously losing money. But for every recovery story you hear, there are 10 other companies that didn’t recover and have continued to bludgeon shareholders.
Follow the Money
Trust me, you can find plenty of successful companies who continue to create profits, and thus positive annual earnings, year after year after year. These are the ones that often make the best investments in fact.
The way that a stock gains a negative PE ratio is quite simple. A positive PE ratio reflects positive annual earnings, while a negative PE ratio stems from negative annual earnings.
As such, the example of stock A shown above with a negative P/E of 17 actually signals more of a value trap than a value play, even though the P/B ratio is extremely attractive at 0.35.
Don’t take my word for it. Take a look at my research. I’ve extensively looked at the major bankruptcies of the last 2 decades to learn what the characteristics of a company about to go bankrupt look like. Bankruptcy is the ultimate value trap, and as an individual stock picker it can be the biggest detriment to an otherwise successful strategy.
Negative PE Ratio = Negative
After looking at 30 of the biggest bankruptcies, I found that the most common and measurable characteristic was negative earnings. All things considered, a company with negative earnings is a ticking time bomb. It will either violently recover, or violently not.
A prudent investor like yourself should not subject yourself to that kind of drama. Leave the drama for things not related to your hard earned savings.
A negative PE ratio should be avoided at all costs.
As far as stock B, I’d treat it like any other stock. While the P/E is low, the corresponding P/B is high. Now if I owned a stock like B, I’d probably hold it. But when it comes down to if I’d buy more, I’d have to weigh my options against other opportunities in the market.
In other words, if I can find a better stock idea at a lower valuation, then I’d rather put new money there instead of in stock B. A quick glance at my model portfolio at The Sather Research eLetter reveals that there are plenty of better deals out there.
**NEGATIVE PE RATIO – WHAT TO DO?**
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