What is Price-earnings ratio ?
The Price-earnings ratio, mainly known as P/E ratio or P/E, or short-form as PER, is the ratio of a company’s which share a price to the companies by earnings per share. This ratio is used mainly to take out companies valuation and determine whether the price per Share is overvalued or undervalued.
What is Negative PE Ratio?
The P/E ratio, which has in the market value of any stock, is compared with the company’s earnings. The P/E ratio shows when a market is willing to pay today for this stock based on its future earnings or past earnings. It is very much possible for any stock to have a negative P/E ratio.
Explanation of price to earnings ratio with negative PE Ratio
The relationship between stock prices and earnings of a company’s per-share completely depends on the Price Earnings Ratio of a company.
According to Standard Formula, earnings are a financial ratio that includes a division of net earnings. Which commonly available for stakeholders over a certain period with their average outstanding shares.
According to the per-share formula, the earnings are used to indicate the company’s ability to produce net profits for various common stakeholders. This ratio is also a popular ratio that gives better and proper sense to the investors of the company’s fair value.
The fair value of the product application and sold or traded in the belonging markets is under normal conditions. It is also not to one that the company has liquidated with a negative PE Ratio.
The prices paid per unit of current earnings can indicate the market’s expectations, which is done by the price-earnings ratio. The net income is a key item that is an income statement and considered in all three core financial statements.
When earnings value a company’s stock, it is considered important because investors of a company want to know how profitable a company is and even how profitable a company’s profit margin can be. A measurement of a company’s earnings is a profit margin in which is also relative to its revenue in accounting and finance.
In the future, the three main profit margins of a company can be metricized. If there is no growth in the company and even the current levels of its earnings remain constant, then the earned price can be interpreted in Negative PE Ratio.
Formula and calculation of Price-earnings ratio-
Earning Per Share : Net Profit / Number of Equity Share
The calculation of the price-earnings ratio is done by dividing both the market value price per share with the company’s earnings per share.
Earnings per share of a company are the amount of a company’s profit allocated with each outstanding share of a company’s common stock and serving it as an indication of its financial health.
In other words, earnings per share of a company are the portion of a company’s net income or total income that can be earned according to the per share and if all the profits were even paid out to its particular shareholders.
Earnings per share are usually typical for analysts and traders for the proper establishment of a company’s financial strength.
Various variants of price-earnings ratio with negative PE Ratio
While the calculation behind the price-earnings ratio is simple, price is divided by earnings; several other factors in which the price or earnings are used.
Commonly the price-earnings ratio is mostly calculated using the current price of a stock in which one can use their average price over some time. In this, it can be seen that there are three varying approaches to the price-earnings ratio when it comes to the earnings part of the calculation. In this, each of three will tell you different things about a stock.
Following are the three points explaining various variants of price earning ratio:
Trailing Twelve Month Earnings-
The first way to calculate the price-earnings ratio is using a company’s earnings over the past 12 months. It is referred to as the trailing price-earnings ratio or trailing twelve-month earnings.
Factors from the past earnings have the benefit of using actual and reported data. This approach is widely used for the evaluation of companies.
Several websites related to finance, such as Google Finance and Yahoo Finance, normally use the trailing price-earnings ratio. Investment apps that are popular and a few of them like the M1 Finance app and Robinhood use trailing twelve-month earnings.
E.g., each of these sites recently submitted a report that the price-earnings ratio of Apple is at or about 33 in early August 2020.
The calculation of the price-earnings ratio can also be used to estimate a company’s future earnings.
While the forward price-earnings ratio does not receive benefits from reported data, it has particular benefits of using the best available information of how the market expectations of a company to perform are done by the coming year.
Morningstar which is a financial services company which has its headquarter in Chicago uses this method. They call it Consensus Forward price-earning. By using this method, Morningstar calculates Apple’s price-earnings at about 28 as early August 2020. Which has ultimately improve the Equity of the Company.
The Shiller P/E Ratio-
The approach, which is counted as third, is used to calculate average earnings over some time. The most well-known example of This approach is the most well-known example named Shiller price earning ratio. It can also be called the cyclically adjusted price-earnings ratio with negative P/E Ratio.
The calculation of the Shiller price-earnings ratio is done by dividing the price by the average earnings over the past decade and has been adjusted for inflation. It is also widely used to measure the valuation of the S&P 500 (Standards and Poor 500) index. The Shiller price-earnings of the Standards and Poor 500 currently stands at just over 30 as of early August 2020.
Usage and Limitations of Price-earnings Ratio and negative PE Ratio
The valuation of a stock or index is the most commonly used price-earnings ratio to gauge. The stock which is relative to its earnings is the higher ratio which is even more expensive. In the same way, the lower the ratio is, the less expensive the stock will be.
Stocks and equity mutual funds are also classified as “Growth” or “Value” investments. It is an investment that has an above-average price-earnings ratio also Negative PE Ratio.
For example, it might be classified as a growth investment.
The Price-earnings ratio of Amazon is currently at about 123. An example of a growing company as stocks and equity mutual funds investments with a below-average price-earnings ratio would be classified as a value investment.
Citigroup would be considered a value company because of having a price-earnings ratio under 9 far away from Negative PE Ratio.
The Price-earnings ratio can also be used for the comparison of two or more companies.
Further, if we compare one company’s stock price with another company’s stock price, it indicates the investor nothing about their relative value as an investment.
Limitations price-earnings ratio and negative PE Ratio
Few important limitations that are most important to take into account also been taken with the price-earnings ratio.
It helps the investor believe that there might be only one single metric to provide a comprehensive insight into an investment decision.
As per holding shares, non-profitable companies have no earnings or negative earnings, leading to a challenge in calculating their price-earnings.
Opinions may also vary on how to deal with this situation.
Others assign a price-earnings of 0, and some say that there is a negative price-earnings. There is unavailability or nonexistence of earnings while it is just considered. For comparison, it is not even interpretable until a company becomes profitable.
The limitation in which the primary consideration is used is which price-earnings ratios emerge, and it is compared with the price-earnings ratios of various companies.
Growth rates of companies and even considering their valuation may often vary wildly between various sectors. It does both of the different ways companies earn money in the different timelines during which companies earn that money.
In this case, the usage of the price-earnings ratio can stand as a comparative tool. Even if it is considered a company in which the same sector of this kind of comparison led to the only kind that will yield productive insight.
For example, it is assumed that it is not reliable when it comes to believing that one has a superior investment.
Pros and Cons of Price-earnings ratio-
We are having many pros and cons of the price-earnings ratio; below point are some of them:
Price-earnings ratio pros:
• It has simple figures for calculation, and it also has readily available data points for most stocks.
• It helps investors to estimate the value of stock quickly.
• It helps investors to compare a stock with or among other stocks.
Price-earnings ratio Cons: This will help to reduce Negative PE Ratio
• It does not provide a proper or complete stock analysis of a company.
• With varied accounting practices, this ratio can be manipulated.
• It does not update in real-time.
• It is completely based on earnings figures from the past.
• A company’s debt is not taken into account.
Comparison of price-earnings ratio with negative PE Ratio.
The following points below indicate the best comparison to use for the price-earnings ratio:
For the most part, competitors from the industry having similar businesses and similar earning models. This means that price-earnings ratios in the following industry should be around the same. The differences should be positive, which will likely reflect the quality of a business or the growth potential.
It will be a one of good investment if you think that a company having a superior business but still has a low price-earnings ratio.
As we look at a company’s stock price-earnings ratio history, then one of the best ways to avoid purchasing stocks with a perpetual low price-earnings ratio. If a stock’s value according to the price-earnings ratio is not favorable and has been for years, then the specific catalyst will make the trade at higher prices in the future.
The stock’s price may fall soon if the growth rate starts declining even after trading at its highest ever price-earnings ratio.
It may be willing to accept a high price-earnings ratio even if a company is closing at the beginning of its life cycle and still proving its business model. In this also you can expect multiple expansions by the company over the coming years.
If a company is growing slowly or not growing, it may be varying in multiple contractions, and in that case, it would be good to accept only low price-earning ratios.
A company with rapid growth might be worth a high price-earnings ratio; in this, you can even compare ratios by calculating a company’s price-earnings ratio as double the company’s projected earnings growth rate.
Simply dividing a company’s price-earnings ratio, we find either the earnings growth rate from the past few years or an analyst-supplied projection for the next few years. Companies with low or even we can say that below 1 having price-earnings growth ratios may be worth somewhat even higher price-earnings ratios.
Issues involved in price-earnings ratio and negative PE Ratio.
Even if the price-earnings ratio is useful, it is also a popular tool in stock valuation; it can also rely on it as a standalone criterion. It would also help you use it with other valuation techniques to arrive at the correct picture. The price-earnings ratio is also affected by the following parameters:
• Calculating the price-earnings ratio accounts only for the earnings and even for the market price of an equity share. It does not look into the debt aspect of the company.
Therefore, some companies are highly leveraged, and they also can be considered risky investments.
However, a high price-earnings ratio of such companies will be not bringing forth this aspect.
• The price-earnings ratio mostly assumes that the earnings will be remaining constant shortly. However, these earnings are dependent on many other things, and they can also be volatile.
• Throughout its life cycle, an investor needs to invest in a company that keeps generating cash flows at an increasing rate. The Price-earnings ratio does not indicate whether a company’s cash flow will increase or decrease in the coming years.
Hence, as regards the direction of growth, it leaves room for uncertainty.
• There is an assumption that a company having a lower price-earnings ratio of 10 is cheaper than a company with a price-earnings ratio of 12.
However, when you don’t get information about on of the quality of earnings of the company.
If the company that is trading cheap has a low quality of earnings, it can’t be an ideal investment.
Comparing companies with negative PE Ratio:
The usage of the price-earnings ratio will help you know which sectors are overpricing or underpricing, but you can also compare the prices of companies in the same sectors.
For example, if two companies like DEF and KLM are selling per share for $50, it might be far more expensive than the others. This also depends on the profits and even growth rates of each stock. If DEF reported earnings of $10 per share, and KLM is reporting earnings of $20 per share. Then DEF must be having a price-earnings ratio of 5, while KLM has a price-earnings ratio of 2.5.
KLM is better at purchasing at that time but because of the lower share prices and similar earnings.
So, for each share purchased, you will be getting $20 of earnings from KLM rather than $10 in earnings from DEF.
When a price-earnings ratio is considered, it is to be high or low, depending on the sector. For instance, it is like the IT and telecom sector companies have a higher price-earnings ratio than the companies from other industries like manufacturing, textile, etc.
The Price-earnings ratio also depends on various external factors. A merger and acquisition are announced by a company that the price-earnings ratio will increase and reduce the Negative PE Ratio. As it is indispensable for examining the backdrop of the company and considering all constituents before investing.
Frequently Asked Questions.
What is the good price-earnings ratio?
– Necessarily, to be good or bad price-earnings ratio completely depends on the industry in which the company is operating. Some industries might be having high average price-earnings ratios, while others will have lower ratios.
E.g., as of January 2020, US coal companies that were trading publicly had an average price-earnings ratio of only about seven but in comparison to more than 60 for software companies.
For particularly getting a general idea of whether a particular price-earnings ratio is higher or lower, you can compare its average price 0 earnings of the competitors within that particular industry.
What is better to have a higher price-earnings ratio or a Negative PE Ratio?
Many investors will recommend that it is better to purchase shares in companies having lower price-earnings because it also means that you are paying less for every dollar of earnings you receive. In this sense, lower price-earnings are like having a low price tag, making it more attractive, making the investors looking for a bargain.
However, understanding the reasons behind a company’s price-earnings is also important. If a company has lower price-earnings, then it would be because of their business model, which would be fundamentally declining, and hence the apparent bargaining might be an illusion.
What does the price-earnings ratio of 15 mean?
– In a normal way, it can also be referred that the price-earnings ratio of 15 would mean that the current or present market value of the company would be nearly equal to 15 times its yearly earnings. It can be said that it would take 15 years for you to earn back your initial investment through the company’s ongoing profits if you are hypothetically purchasing 100% of the company’s shares will grow Company assets.
How to overcome a negative PE Ratio?
Sell the stock with the stock which had a positive Price Earning ratio. Also, swap with the stock which price Earning Ratio in long term is more profitable.
My Name is Nadeem Shaikh the founder of nadeemacademy.com. I am a Qualified Chartered Accountant, B. com and M.Com. having professional and specialize experience in field of Account, Finance, and Taxation. Total experience of 20 years in providing businesses solution in Taxation, Accounting, and Finance with all statutory compliance with timely business performance Financials reports. You can contact me on email@example.com or firstname.lastname@example.org.