Investing in Stocks with Negative Earnings
Investing in a stock comes with one simple goal: profit. Stocks move higher as companies grow and profits increase, making shares more valuable as a result. But sometimes, companies that post positive earnings have a losing stock performance and companies that post losses can end up with winning stock performances.
Analyzing a stock with positive earnings is a fairly straightforward process. Quarterly earnings results are used to determine how much the stock is worth relative to its stock price. The price-to-earnings ratio, or P/E, is a benchmark commonly used by investors to identify whether a stock is a growth or value stock. Without earnings, valuing a stock becomes more difficult.
Negative Earnings Doesn’t Translate to Losses in the Market
A company issues stock in order to finance further growth. Sometimes, the company is already profitable, but many times the only thing a company really sells to investors is future growth. In this case, investors will need a thorough understanding of the underlying company’s business model in order to project future growth prospects.
Projecting earnings isn’t difficult. All it takes is a simple regression model that takes into account past performance in order to predict future performance. Investors need to assume a fair growth rate, which will decline as the company grows so estimates become more difficult to predict the further out you go. One of the biggest dangers to this method is assuming too high of a growth rate or picking a stock that takes too many years to actually post positive earnings.
Negative earnings mean different things depending on the industry, as well. Companies leaden with debt like those found in the utility sector are poor investment choices if they have negative earnings. The difficulty of managing interest debt and low growth makes negative earnings a virtual death sentence. The tech industry, on the other hand, isn’t affected very much by negative earnings. A lack of overhead expenses and fast paced growth environment means companies outgrow early negative earnings rather quickly.
One thing investors should be wary of is companies that were profitable, that now post negative earnings. While turnaround stories do happen, the lack of growth and poor performance is usually indicative of a larger problem that can’t be attributed to a temporary bear market.
Investors should always perform due diligence before putting actual money into a stock. Stocks with negative earnings should be viewed cautiously, but not avoided entirely. While value stock investing generally avoids negative earnings, growth stocks often have negative earnings. High enough growth will outweigh any current negative earnings results when positive earnings are expected at a later date. As with most stocks, growth is key in picking the right stock with negative earnings.