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Why are negative valuation ratio values not included in comparative company analysis? This appears to be a general practice ("Valuation: Measuring and Managing the Value of Companies, University Edition" (2010), pg.312 and "Investment Valuation 3rd Edition" by Aswath Damodaran). Eg. from Damodaran

The fact that multiples such as the price-earnings ratio can never be less than zero and are unconstrained in terms of a maximum results in distributions for these multiples that are skewed toward the positive values[...] When the earnings per share are negative, the price-earnings ratio for a firm is not meaningful and is usually not reported. (Page 493)

(what does that mean, "not meaningful"?) and in that same chapter (Chapter 17), they have a study question...

  1. Generally, we cannot compute PE ratios for firms that have negative earnings. What are the implications for statistics such as industry- average PE ratios?

Again, the exclusion of negative valuation ratios (eg. P/E) seems to be a general practice and I'm curious as to why. If this perception is wrong and in fact many analysts do include negative ratio values in thier comps analysis, could someone also please let me know the reasoning why?

  • Please quote from the paragraph, otherwise the only people who can answer are those that have the book or can find it searchable online. – mhoran_psprep Sep 12 at 10:34
  • It is not specific to the particular book, just something I have seen in several places. Will try to find examples in other books I actually have. – lampShadesDrifter Sep 12 at 10:48
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    Then why mention the edition, and page number. An example is required to understand the nature of the question. – mhoran_psprep Sep 12 at 10:50
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The price to earnings ratio is useful if and only if you expect there to be a relationship between the stock price and earnings. Otherwise, the number is not meaningful-- it would be like taking the ratio between my StackExchange reputation and my shoe size. You could calculate it, it just wouldn't be meaningful information.

Fortunately for us, most of the time there is a relationship between the stock price and earnings. At least when we're talking about nice, established companies. If we've got a nice well established widget manufacturing company, it will (hopefully) be generating a profit that grows slowly over time, it's P/E ratio will be relatively stable, and those increasing profits will lead the stock price to increase slowly but relatively steadily. The P/E ratio is a useful way measure to value this company or to compare it with its peers. This is the sort of company that most books on valuation are going to focus on both because it is relatively easy to value them and because there is broad agreement about the valuation process.

But there are plenty of times that the P/E ratio isn't meaningful because there isn't an expected relationship between price and earnings. If you're looking at a rapidly growing startup, for example, you'd want the company to be losing money initially because it is investing in growing the business. You wouldn't expect earnings to be driving the stock price so the P/E ratio isn't meaningful. You'd need to find some other metric that is driving the price (i.e. revenue, subscriber count, market share, etc.). If the nice widget manufacturing company in the previous paragraph loses money this quarter, the P/E ratio would be much less useful without knowing why it was losing money-- was it investing in a huge expansion in its lunar widget manufacturing base or have orders dried up because the newest widget model is a dud? If you're going to value the company, you'd want to use a different approach.

Of course, there are times that the P/E ratio can be positive but not meaningful. If the rapidly growing startup happens to have an occasional quarter that it minimally profitable, the P/E ratio would be greater than 0 but it still wouldn't be meaningful. Earnings still wouldn't be driving the stock price, so it doesn't matter whether the P/E ratio is -20 or +10,000, it isn't a meaningful number.

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