PE Ratio in Mutual Fund? Meaning, Types & Calculation

In the world of investing, there are various metrics that help investors in assessing the value and potential of their investments. One such crucial metric is the Price-to-Earnings (PE) ratio. Understanding the PE ratio in mutual funds can provide valuable insights into the fund's composition, valuation, and potential future performance. This comprehensive guide will explore the concept of PE ratio in mutual funds, its calculation, types, and significance for investors.

What Is PE Ratio in Mutual Fund?

The PE ratio stands for price to earnings. It compares how much the investment is earning by way of profit versus what the market value is. In the case of stocks, it is calculated by dividing the current market price of a stock by its earnings per share (EPS). It is a good indicator of whether an investment is expensive or cheap relative to its earnings.

So, what is the PE ratio in mutual funds? The mutual fund PE ratio essentially tells investors how much they are paying for each unit of earnings generated by the companies in the mutual fund's portfolio. While for stocks, the current market price is compared with the profits, for mutual funds investors use the NAV in mutual fund. PE ratio in mutual funds provides a quick snapshot of whether the fund's holdings are, on average, expensive or cheap relative to their earnings. A higher PE ratio suggests that investors are paying more for each unit of earnings. It may also indicate higher investor expectations for future growth. Conversely, a lower PE ratio may indicate that the fund's holdings are undervalued, or that the market has lower growth expectations for these companies.

It's important to note that the PE ratio of mutual funds is not directly comparable to the PE ratio of an individual stock. Instead, it is an aggregate measure of the valuation of all the stocks within the fund's portfolio.

PE Ratio Formula and Calculation

The basic formula for calculating the PE ratio is:

PE ratio = Market Price per Share / Earnings per Share (EPS)

For an individual stock, this calculation is straightforward. However, the PE ratio for mutual funds is slightly complex due to the diverse holdings within the fund's portfolio. Here's how the mutual fund PE ratio is typically calculated:

1. Calculate the PE ratio for each stock in the fund's portfolio.

2. Multiply each stock's PE ratio by its weight or allocation in the portfolio.

3. Add up all these weighted PE ratios to get the fund's overall PE ratio.

For example, let's consider a simple mutual fund with three stocks:

- Stock A: PE ratio of 15, 40% weight in portfolio

- Stock B: PE ratio of 20, 35% weight in portfolio

- Stock C: PE ratio of 25, 25% weight in portfolio

The fund's PE ratio would be calculated as follows:

Fund PE Ratio = (15 × 0.40) + (20 × 0.35) + (25 × 0.25) = 19.25

This calculation provides a weighted average PE ratio that reflects the overall valuation of the holdings, or AUM in mutual funds.

Types of Price-to-Earnings (PE) Ratio

When analyzing PE ratio in mutual fund, it's essential to understand that there are different types of PE ratios, each with a specific purpose. The 2 main types of PE ratios are:

1. Trailing PE Ratio: This is the most commonly used PE ratio. It is calculated using the company's earnings over the past 12 months. The trailing PE provides a historical perspective on a company's performance.

2. Forward PE Ratio: This ratio uses projected, or future earnings of the company for the next 12 months instead of historical earnings. Forward PE can be useful for anticipating future performance but relies on earnings estimates, which may not always be accurate.

For mutual funds, these different types of PE ratios can be applied to the fund's holdings, providing investors with various perspectives on the fund's overall valuation.

Absolute PE vs Relative PE

When evaluating PE ratios in mutual funds, it's crucial to understand the concepts of Absolute PE and Relative PE:

Absolute PE

Absolute PE refers to the standalone PE ratio of a stock or mutual fund. It provides a snapshot of the current valuation. While useful for quick assessments, absolute PE has limitations since it doesn't account for factors such as industry norms, market conditions, or historical trends.

Relative PE

Relative PE, on the other hand, compares the PE ratio of a stock or mutual fund to a benchmark or parameter, such as the overall market, a specific sector, or historical averages. This approach provides more context and can help investors determine if a fund is overvalued or undervalued, as compared to its peers or the broader market.

For example, if a mutual fund focused on technology stocks has a PE ratio of 25, this might seem high in absolute terms. However, if the average PE ratio for technology sector funds in the market is 30, then the fund could be considered relatively undervalued.

Understanding both absolute and relative PE is crucial for mutual fund investors, as it allows for a more comprehensive evaluation of a fund's valuation in the context of its investment strategy and market conditions.

What is a Good PE Ratio?

Wondering how to invest in mutual funds based on the PE ratio? Determining what constitutes a good PE ratio of mutual fund schemes is not straightforward, as it depends on various factors. So, how can you invest in mutual funds? There are some general guidelines and considerations that you can keep in mind:

1. Comparison to Benchmark: A good PE ratio for a mutual fund is often considered one that is lower than, or at best, in line with its benchmark index. For example, if a large-cap equity fund has a lower PE ratio than the  Nifty 50 index or BSE Sensex index, it might be considered adequately valued. Also check for the fund's exit load, or the charges levied by the mutual fund if you decide to withdraw your funds before the stipulated time.

2. Sector Considerations: Different sectors typically have different PE ranges. For instance, technology and growth-oriented sectors often have higher PE ratios compared to defensive sectors. Therefore, a good PE ratio should be evaluated in the context of the fund's sector focus.

3. Historical Perspective: Comparing a fund's current PE ratio to its historical average can provide insights into its relative valuation. A PE ratio significantly below the fund's historical average might indicate a potential entry point for investors.

4. Growth Prospects: A higher PE ratio might be justified if the fund's holdings have strong growth prospects. If the PE ratio has been rising over time, it means that investors are paying a higher price for the same level of earnings. Conversely, a lower PE ratio might be appropriate for funds focused on mature, slow-growth companies.

5. Market Conditions: During bull markets, PE ratios tend to expand, while they often contract during bear markets. Consider the broader market context when evaluating a fund's PE ratio.

6. Investment Strategy: Some mutual funds, particularly those following a growth strategy, may intentionally seek out stocks with higher PE ratios due to their growth potential. In contrast, value-oriented funds typically target stocks with lower PE ratios.

7. Risk Tolerance: Generally, a lower PE ratio is associated with lower risk, as it implies you're paying less for each unit of earnings. However, this is not always the case, and other factors should be considered alongside the PE ratio.

It's important to note that while the PE ratio is a valuable tool, it should not be used as a single parameter for evaluation. Investors should consider other metrics and factors, such as the fund's performance history, expense ratio, holdings, and overall investment strategy, to make informed decisions.

Conclusion

The PE ratio is a crucial metric for evaluating mutual funds, offering a deep dive into the valuation of a fund's holdings and its potential for future growth. By understanding how to calculate and interpret PE ratios, investors can make more informed decisions about their mutual fund investments. Investors should also look out for the Sharpe ratio in mutual funds, which shows the returns earned for risk undertaken while investing in a particular mutual fund scheme.

However, it's essential to remember that the PE ratio is just one piece of the puzzle. While it provides valuable information about a fund's valuation, it should be used along with other financial metrics and factors. Factors such as the fund's investment strategy, historical performance, and overall market conditions all play important roles in determining the potential of a mutual fund investment.

Moreover, the interpretation of PE ratios can vary depending on the type of fund, market conditions, and individual investor goals. What might be considered a good PE ratio for one investor or in one market context might not be suitable for another.

Ultimately, successful mutual fund investing requires a comprehensive approach that considers multiple factors. The PE ratio serves as a valuable tool in this process, helping investors gauge the relative value of their investments and make more informed decisions in their pursuit of financial goals.

Frequently Asked Questions

1. What is a good PE ratio for mutual funds?

There is no single number that could be considered a good PE ratio. The answer also depends on the fund category. For example, value funds would usually have a lower PE ratio. In general, it's a good idea to compare the PE ratio of the mutual fund with the underlying benchmark that it tracks. Ideally, the PE ratio should be either lower or in line with the benchmark.

2. How do you interpret price earning ratio?

Price earning ratio is to be read as what investors are paying for the proportionate earning of the investment. If the PE ratio is high it means valuations are high for that particular investment. 

3. How to calculate PE ratio in mutual funds?

To determine each security's price to earnings ratio you can use the below-mentioned formula.

PE ratio = Market Price per Share / Earnings per Share (EPS)

When all of the securities in the portfolio have had their P/E ratios determined, the mutual fund scheme's P/E ratio is determined by taking each security's P/E ratio and allocating weights based on how much of that security is in the portfolio.

4. Is a high PE ratio good?

A high PE ratio simply means that the stock is in demand, and that investors are willing to pay more to acquire the same. It does not reflect on the company’s financials.

Generally, companies (and by extension, funds) with higher expected earnings growth rates tend to have higher PE ratios, as investors are willing to pay a premium for future growth potential.

5. Is the PE ratio for mutual funds a good indicator?

The PE ratio is most useful for comparing equity mutual funds within similar categories or sectors. It's not applicable to bond funds or other non-equity asset classes.

6. Is a negative PE ratio good?

While individual stocks can have negative PE ratios if they report losses, it's rare for a mutual fund to have a negative PE ratio. However, this is not good news, since it means that all the holdings of a portfolio have gone down.

 

These materials are not intended for distribution to or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation.  The distribution of this document in certain jurisdictions may be restricted or totally prohibited and accordingly, persons who come into possession of this document are required to inform themselves about, and to observe, any such restrictions.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.