Does the Market Reward Negative P/E Firms?
Yes, but size and liquidity matter.
May 14, 2013
While there is a lot of research examining the performance of firms with positive price-to-earnings (P/E) ratios, there isn’t any research with regards to the performance of negative P/E firms and how this performance compares with that of positive multiple firms.
Recently, I set to examine the performance of negative P/E U.S. firms over the period 1968-2011 and compare it to the performance of positive multiple firms.
I have 90,423 annual observations belonging to 8,570 unique positive P/E companies and 22,133 annual observations for 6,232 unique firms with negative P/E ratios.
Table 1 shows that the median operating margin (EBIT/Revenues) and asset turnover (Revenues/Assets) for the positive multiple firms are 9.88% and 1.167, respectively, while their median annual growth rates of revenues, EPS and EBIT are all positive. The median firm is not overleveraged as the debt to equity ratio is .28 and has a market cap of US$182.5 million. Median values for cash to assets and current ratio (current assets/current liabilities) are 3.7% and 2.1, respectively. The median firm trades about 48% of the shares outstanding over the year.
Comparing negative P/E with positive P/E firms, one can see that firms with negative P/E ratios have very low or negative median operating margin, EPS, EBIT and revenue growth rates as opposed to very positive ones for firms with positive multiples. Additionally, negative P/E firms have lower market cap values and higher debt, asset turnover and stock liquidity (annual trading volume to shares outstanding) than firms with positive multiples.
More importantly, there is a large difference between mean and median returns for negative P/E ratio firms vis-à-vis corresponding returns when firms have positive multiples, as can be seen from the Table 1. Although, on average, returns are much higher for negative P/E firms than positive ones, fifty percent of the negative P/E firms experience a return less than zero as opposed to positive P/E firms whereby 50% of the returns are less than 7.99%. This is also true when we look at individual exchanges, particularly for AMEX and NASDAQ firms where the median return is highly negative and the mean return highly positive.
Firms with negative multiples are thus different than firms with positive multiples. They experience, on average, very high stock returns even though the majority does not, resulting in much larger differences between mean and median returns than firms with positive multiples, both for the total sample and by exchange. One can find real gems within negative P/E firms, but he/she needs to be extremely cautious as the majority of such firms are anything but.
My research also shows that negative P/E firms are different than positive P/E firms in another dimension. While smaller and less liquid positive P/E firms tend to do better than average, for negative P/E firms the bigger and more liquid firms outperform. The markets seem to reward liquidity and size when it comes to negative P/E firms.
For example, Table 2 shows the bottom 13 and the top 13 negative P/E firms with, respectively, the lowest and the highest combinations of market cap and stock liquidity in the U.S. market chosen as at the end of March 2012 and their performance from April 2012 to March 2013. The average return of the small market cap/liquidity group was -5%, whereas the large market cap/liquidity group averaged 20%. Among the 26 stocks, fifty percent have positive returns and 50% negative. The overall average return for these stocks is 7.5%. However, if we exclude CLWR and BMRN, the gems, then the average return for the remaining 24 stocks is -0.25%, reinforcing the summary evidence presented in and conclusions drawn from Table 1.
Table 1 (Click on image to enlarge)
Table 2 (Click on image to enlarge)