While the stock market has a high earning potential, you need to be cautious about equity investments, especially through mutual funds.
You must comprehend the components of income and balance sheet statements of the scheme’s underlying companies and learn how to apply various financial ratios in order to pick a fundamentally sound fund.
One ratio you should include in your investment strategy is the PE ratio. Let’s understand what is PE ratio in mutual fund in this article.
What is PE Ratio in Mutual Fund and Stocks?
The Price-to-Earnings (P/E) Ratio is a financial metric that compares a company’s stock price to its earnings per share (EPS).
This indicates the price investors are willing to pay for every Rupee of earnings. This ratio reflects the market’s valuation of a company.
A higher P/E suggests that investors expect future growth, while a lower P/E may indicate the stock is undervalued or the company faces challenges.
Analysts use it to compare firms within an industry or against historical data.
For a mutual fund, the P/E ratio is a weighted average of the P/E ratios of all the underlying stocks it holds. The weight is based on the proportion of each stock’s holding within the fund.
How Does P/E Ratio Work?
Let’s say a mutual fund, M, holds stocks A, B, and C.
- M = (P/E of A * % holding of A) + (P/E of B * % holding of B) + (P/E of C * % holding of C)
Example:
- Mutual fund M holds:
- Stock A has a P/E ratio of 20, representing 30% of the fund’s holdings.
- Stock B has a P/E ratio of 15, representing 40% of the fund’s holdings.
- Stock C has a P/E ratio of 25, representing 30% of the fund’s holdings.
Now by applying the above formula:
M = (20 x 0.3) + (15 x 0.4) + (25 x 0.3), M = 6 + 6 + 7.5, M = 19.5
Therefore, the mutual fund M has a P/E ratio of 19.5.
Different Types of P/E Ratio in Mutual Funds
P/E ratios, either in stocks or mutual funds (PE’s weighted average), are basically of the following two types:
1. Trailing Twelve Months P/E Ratio
The TTM P/E Ratio compares an underlying company’s current share price to its per-share earnings over the past year. It is calculated by dividing the current stock price by the EPS for the last 12 months.
2. Forward P/E Ratio
This ratio estimates the value of an underlying company’s stock based on expected future EPS. It is calculated by dividing the current stock price by the projected EPS. This forward-looking measure helps investors gauge market expectations for a company’s growth and profitability.
Complementing P/E with metrics like the P/B ratio, growth rates, and a few others are recommended for a more transparent snapshot of the scheme’s underlying companies’ health.
Understanding Absolute PE vs Relative PE Ratio
Absolute PE is the same as normal PE at a specific point in time. In contrast, the relative PE ratio compares the current absolute PE ratio to the company’s historical PE ratios or to a benchmark’s PE ratio. It assesses whether the scheme’s underlying stock is valued higher or lower than its historical performance or a market index.
For example, if an underlying company’s PE ratio has fluctuated between 10 and 30 over the past years and is currently 20, the Relative PE Ratio would be 0.67 (20/30) compared to the high. This indicates the stock is at 67% of its historical high.
Limitations of PE Ratio
- A mutual fund’s P/E is a weighted average, combining potentially undervalued and overvalued stocks. It doesn’t pinpoint specific opportunities or risks within the fund. Analyze the fund’s holdings for a more complete picture.
- The PE Ratio is not ideal for comparing companies across different industries, as industry norms can vary significantly.
- A low PE might indicate negative market sentiment or underlying issues within an underlying company that require further investigation.
- EPS, used in PE calculations, can be misleading. Due to different accounting practices, an underlying company can report positive earnings but have negative free cash flow.
- PE does not account for underlying companies’ growth rates, which can be a critical factor in valuation.
- The ratio can be skewed by one-time events or changes in accounting rules, which may not reflect the underlying company’s ongoing financial health.
Conclusion
The P/E ratio contrasts a company’s stock price to its earnings per share. It reveals investor sentiment and potential value.
While useful in mutual funds, it is not without limitations, such as industry variations and accounting discrepancies. You should use other ratios along with P/E to make an informed decision.
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