P/E ratio is one of the most well recognized ratios in the world of stock market investments. P/E ratio refers to the ratio between the price of the stock and the earnings per stock of a company. It is an integral part of fundamental analysis and can be used to evaluate whether a company is undervalued or overvalued. However, you might have noticed that some companies do not have any P/E ratio. Why does this happen?
Why do some companies have no P/E ratio?
(source : Fundamentals of Inox Leisure)
P/E ratio consists of two factors – price of the share and the earnings per share of the company. The price of the stock is always a positive number. However, the earnings per share can be negative if the company is making losses! The P/E ratio is only applicable when the company makes a profit because otherwise it just doesn’t make much sense. Now, you might be wondering that the P/E ratio should just be a negative number when the company is a loss making company. But a negative P/E ratio is generally not reported, instead there is no P/E ratio assigned to the company.
Why can’t companies have a negative P/E ratio?
Even though a company can theoretically have a negative P/E ratio, it is a standard practice to report no P/E ratio rather than a negative P/E ratio. Let’s consider two cases, one of a profit making and another of a loss making company.
If a profitable company has a P/E ratio of 20 and you invest Rs. 100 into the company, then that company would be able to make those Rs. 100 as earnings in 20 years assuming that the company’s profits are constant over the years. Simply put, investing in a company with a P/E ratio of 20 means that an investor is willing to pay 20 times the earnings of the company to become a shareholder. It makes a lot of sense when the company is profitable.
However, the definition of P/E ratio begins to crumble when the company is reporting losses. If a company has a stock price of Rs. 100 & the EPS (earnings per share) of -Rs. 10 or (Rs. 10), it might seem like that the P/E ratio becomes -10 or (10) as per the mathematical formula.. However, things stop making sense logically when you try to understand this number. If the company has a P/E ratio of -10 and you invest Rs. 100 into the company, then that company would never be able to generate your invested amount back if the company losses remain constant. The only way the company would ever be able to generate enough money which the investor has invested is only by improving its revenue and hopefully becoming a profitable company. This is why negative P/E ratios (though theoretically possible), makes no sense in practical terms.
A company which is a loss making company has no P/E ratio!
Should investors avoid companies with no P/E ratio?
A company which has no P/E ratio is a company which is a loss making company. Such companies should definitely be avoided by defensive investors. It doesn’t make sense to invest in such companies because the entire goal of a business is to generate profit for its shareholders. A loss making company just keeps on digging a bigger & bigger hole for itself and its shareholders.
However, for an aggressive investor there are many instances where a loss making company can be a good investment opportunity. A loss making company could be making losses due to many reasons.
- The sector to which the company belongs is currently going through a depression and is facing a down-cycle.
- The company is aggressively expanding which is resulting in a cash burn.
- The company is currently under a big debt burden.
- The company belongs to a sunset industry & therefore is consistently losing its sales.
Even though there is a requirement of a critical assessment for the company on a case-by-case basis, a company which is debt-ridden or is losing its sales should be a complete avoid for any investor. The company which is currently in a down-cycle has a possibility of shining when the business cycle changes to an up-cycle which can make this company a good contender for the portfolio of an aggressive investor when the first signs of a change in cycle start to appear. An aggressively expanding company is either headed to glory or a complete failure & therefore requires a much closer assessment.
Some companies could also be under a temporary distress due to external conditions causing these companies to bleed money for a short duration. If such companies are available at a cheap price, they could be part of an aggressive investor’s portfolio provided the future prospects are bright for the company.
Conclusion
Profitable companies have a clear P/E ratio which makes them much more easier to analyze. Even though there are certain scenarios where a loss making company can prove to be a good (and risky) bet for an aggressive investor, it doesn’t make much sense for most new investors to invest in such companies. However, the final decision to invest in a company with no P/E ratio depends entirely upon the reader!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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