Decipher the PE Ratio for Mutual Funds

Introduction

Do you know how the PE ratio - full form Price-to-Earnings ratio - can be used to evaluate mutual funds’ investments? Unlike individual stocks, mutual funds require a different approach. In this blog, we will explore the PE ratio’s relevance, its calculation methods, and its role in mutual fund investments.

What is the price-to-earnings ratio?

The measure links a company's share price with its earnings per share (EPS). It tells you how much you pay for one rupee of earnings. This metric acts as an indicator how expensive a stock is.

To understand better, consider you own a small business earning ₹10 lakh per annum. If an investor offers ₹70 lakhs for it, the PE will be 7 (70/10).

It’s a quick way to compare companies. Investors use it to gain insight into a company's market valuation relative to its earnings. The PE figure distills complex data into a simple number, aiding better decision-making.

What does PE ratio indicate in a mutual fund?

An equity mutual fund comprises a variety of individual stocks, which influences how their PE values are calculated. Instead of a single figure, the fund’s PE ratio shows the weighted average of the PE ratios of its underlying equity stocks. This approach reflects each stock's proportion in the portfolio, providing a comprehensive view of its overall valuation.

This PE ratio can provide valuable information. Yet, remember to consider additional factors like historical performance, sector diversification, earnings growth potential and inherent risks.

Price-to-earnings ratio formula and calculation

For equity stock,

P/E ratio = Market value per share / Earnings per Share (EPS)

When dealing with mutual funds, the calculation becomes more complex due to the variety of stocks held. Here, the fund's PE ratio is derived from the weighted average of the PE ratios of all its stocks.

PE ratio (Mutual fund) = Σ (PE ratio of each equity unit * Weightage of each unit in portfolio)

Consider a mutual fund with the following stocks:

Calculating each component:

Sum these values:

7.5+7+4.8=19.3

Therefore, the PE ratio of the mutual fund is 19.3.

Interpreting PE ratio

In mutual funds, the PE ratio offers insights into the fund's investment style.

A portfolio with High PE ratio relative to index can be associated with:

• Growth investing: Focuses on companies projected to grow at a faster rate, which suggests a willingness to pay more now for expected future earnings.
• Sector focus: Sectors that may require high upfront investments or high operating expense in the hope of future profitability such as Internet or new-age companies in India and globally.

A portfolio with Low PE ratio relative to Index can be associated with:

• Value investing: Seeks stocks trading below their intrinsic value for reasons such as near term business headwinds, business potential not fully recognised by the market etc.
• Stable/Mature sectors: The sectors that tend to be less volatile and provide steady returns, as they are essential services and products that people need regardless of economic conditions.

What is a good PE ratio?

Deciphering a good PE ratio isn't straightforward. It fluctuates with industries and market conditions. While no universal benchmark exists, context is key.

Industry benchmarks:

Comparing PE ratios within the same industry/category provides more context. Different sectors have varying average PE ratios. For instance, utilities typically have lower PE ratios compared to tech firms. Thus, understanding industry standards is crucial.

Economic conditions:

Economic cycles greatly impact PE ratios. During booms, they rise due to higher earnings expectations. In downturns, they drop as caution prevails. The economic context significantly shapes what is considered a good PE ratio.

Historical consistency:

Examining a fund’s PE ratio over time can reveal the consistency of the fund’s investment approach. A stable PE ratio relative to its benchmark suggests a steady investment strategy.

In essence, evaluating a good PE ratio requires context and comparison. Industry norms, economic conditions, and investment strategies all influence what’s considered favourable.

Factors considered while using P/E ratio

The PE ratio, though popular, has several limitations for Indian investors:

• Past earnings: It relies on historical data, which might not accurately forecast future performance.
• Sector variations: PE ratios can differ greatly between sectors, making direct evaluation challenging.
• Narrow view: It overlooks important aspects like debt, cash flow, and risk levels.
• Ignoring growth rates: The ratio does not consider how quickly earnings are growing, potentially missing future potential.
• Holistic approach needed: Should be complemented with other financial metrics such as debt-to-equity ratio, price-to-book ratio, and profit margins and earnings growth potential for a full assessment.
• ESG considerations: The PE ratio typically does not account for ESG - Environmental, Social and Governance - criteria, which are increasingly important in assessing a company’s long-term sustainability.

To sum up

For mutual funds, the PE ratio provides essential insights but isn't definitive. Compare these ratios within their category and against benchmarks to understand the fund manager’s strategy. Analyse the PE ratio over time to gauge the consistency of this approach. Use it as part of a broader analysis to enhance your investment approach.

Above article is authored by Quantum.

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