5.6 How Can You Interpret P/E Ratios when Earnings are Zero or
Negative?
Relative
valuation consists of ranking stocks by price ratios.
With a P/E Ratio, this breaks down when a stock has
negative or zero earnings. In these cases the ratio that
preserves ranking is the reciprocal of the P/E Ratio.
The reciprocal is called the Earnings to Price Ratio.
Earnings to Price Ratio = Earnings divided by Price
Example: P/E Ratios versus E/P Ratios
Suppose you
are interested in ranking the following set of similar stocks in
terms of relative over or undervalued on the basis of earnings
and stock prices.
Assume the EPS for this set of stocks is -.20, -.10, 0, 0.10 and
0.20 and that the stock price for each stock is $1.
|
|
EPS |
Price |
P/E Ratio |
Ranking |
E/P Ratio |
Ranking |
|
1 |
-0.2 |
1 |
-5 |
2 |
-0.2 |
5 |
|
2 |
-0.1 |
1 |
-10 |
1 |
-0.1 |
4 |
|
3 |
0.0 |
1 |
Infinity |
5 |
0.0 |
3 |
|
4 |
0.1 |
1 |
10 |
4 |
0.1 |
2 |
|
5 |
0.2 |
1 |
5 |
3 |
0.2 |
1 |
You can see
that hat the ranking is meaningless for the P/E Ratios but
meaningful for the E/P Ratios.
So when faced with positive and negative earnings the E/P
Ratio is preferred for relative valuation.
In the next section we jump from the “bottom line earnings” to
the “top line Sales” by considering the price to sales ratio
next.