Understanding The PE Ratio of A Mutual Fund

We often give importance to a stock’s PE ratio, and sometimes investors make buy or sell decisions based on it. But can we give the same importance to a mutual fund’s PE ratio as we do with individual stocks? Will focusing on a mutual fund’s PE ratio help in finding the right fund for you? Rakesh Deshmukh goes through the scenario in detail [EasyDNNnews:PaidContentStart]

Price and value are two fundamental concepts that every investor must grasp, especially when embarking on an investment journey. While the price of an asset is the amount you pay to acquire it, the value represents its intrinsic worth. This distinction is crucial because, as investors, we often focus heavily on the price—be it of stocks, mutual funds or other instruments without adequately considering their value. 

One essential metric for evaluating a company’s value is the price-to-earnings (PE) ratio, which indicates how much investors are willing to pay for each rupee of the company’s earnings. A high PE ratio may suggest that a stock is overpriced relative to its earnings potential, while a low PE ratio could highlight a potentially undervalued opportunity. Nowadays, access to the PE ratio of any company has become much easier due to technological advancements, empowering investors to make informed decisions without the extensive research previously required. 

However, that is still not the case of a mutual fund’s PE. Have you ever considered the PE ratio of the mutual funds you are investing in or planning to invest your hard-earned money? While many investors focus on the PE ratios of individual stocks, mutual funds often fly under the radar in this regard. But is it really important to track the PE of mutual funds? 

PE Ratio of Mutual Fund
The PE ratio of a mutual fund represents the weighted average PE of the stocks held in the fund’s portfolio. A fund’s PE can be used for comparing funds in its category, or in comparing categories. Here’s how it works: 

PE Ratio of a Stock: For an individual stock, the PE ratio is calculated as the current price of the stock divided by its earnings per share (EPS). It shows how much investors are willing to pay for each unit of a company’s earnings. EPS is the profit that a company makes on a per share basis. So, if the EPS is one, the PE ratio will reflect the price that an investor will pay for this one rupee of the company’s profits. 

Example: If Stock A is priced at ₹100 and has an EPS of ₹5, its PE ratio is : 100/5 = 20 times, means the investor is paying ₹20 for every ₹5 of earnings per share. 

PE Ratio of a Mutual Fund: In a mutual fund, since it holds multiple stocks, each has its own PE ratio. Here, the PE ratio is an aggregate or weighted average of the PE ratios of all the stocks the fund owns. The weighting depends on how much of the portfolio is invested in each stock. Let’s walk through an example to calculate the PE ratio of an equity mutual fund scheme XYZ, which holds four stocks with different weights (Stock A, Stock B, Stock C and Stock D) in its portfolio. The total value of the investment is ₹100,000. 

Thus, the PE ratio of the XYZ equity fund is 16.9 times as showcased above. This table shows how the mutual fund’s PE ratio is derived from the individual PE ratios of the stocks in its portfolio, weighted according to each stock’s contribution to the total portfolio value. 

What Does the PE Ratio Tell You?
Now that we understand how to calculate the fund’s PE, what does it tell us? The PE ratio offers a quick insight into how expensive or cheap the underlying stocks are in relation to their earnings. A high PE ratio suggests that investors are optimistic about the stock’s future growth, while a low PE ratio indicates that the stocks may be undervalued and could present a buying opportunity, or it may be that investors are not finding good growth in the company. 

Meanwhile, there are many other fundamental factors that could be at play. However, how an investor interprets a PE ratio is subjective. For instance, a PE ratio of a company might seem reasonable to one investor, but another may view it as overpriced. This difference in opinion could be due to varying perspectives, such as focusing on growth potential, industry trends, or risks that others might overlook. 

Furthermore, likewise in equity shares, mutual funds in different categories have different PE ratios. Typically, growthoriented mutual funds have higher PE ratios because they invest in companies with strong earnings growth prospects. These companies are often priced higher in anticipation of future earnings growth. Conversely, value-oriented mutual funds often have lower PE ratios because they invest in companies that are currently undervalued but have stable earnings. 

Is PE Ratio a Static Number?
The PE ratio of a mutual fund is not fixed. As we know, mutual funds hold a diverse range of stocks based on their selection criteria and the rules prescribed by the Securities and Exchange Board of India (SEBI) for different categories of funds. Fund managers often buy and sell stocks when they identify good opportunities or reach predetermined targets. Additionally, if there are significant changes in a company’s circumstances, a fund manager may decide to sell a stock that no longer fits the portfolio’s strategy. 

Because of these factors, the mutual fund PE ratio is not static. Share prices fluctuate regularly, and companies release their earnings quarterly, further influencing the PE ratio. Therefore, it cannot be represented by a single fixed number. Let’s consider our previous example, where the XYZ fund’s portfolio consisted of four stocks with varying PE ratios. 

If the fund manager decides to sell Stock D, which has a PE ratio of 33, the situation would change significantly. Initially, the mutual fund’s PE was 16.9. After selling Stock D and replacing it with Stock E, which has a PE of 15, the mutual fund’s PE dropped to 13.3. The high PE of Stock D (33 times) had played a substantial role in inflating the overall PE ratio of the fund. By substituting Stock D with the lower PE Stock E, the average PE ratio of the fund decreased considerably. 

Also, if the mutual fund had not bought Stock E with a PE of 15 times, the scenario would have been different again. You cannot calculate the PE of the cash holding within the mutual fund, and it is next to impossible to predict which stock they are going to buy, at what PE, and with what weights. Thus, caution has to be exercised, and the cash component has also to be factored in while looking at the PEs. Further, many a times, mutual fund houses buy stocks with negative PE ratios, which signifies that the company is not generating profits during a certain period. 

When a mutual fund includes stocks with negative PE ratios, the fund’s overall PE ratio calculation may become skewed. The presence of negative earnings can lead to misleading averages. For instance, if most stocks in the fund are performing well, but a couple have negative earnings, the overall PE ratio may appear lower than it would otherwise be. If we allocate a zero PE to loss-making companies, then a fund’s PE ratio becomes less relevant, making it less indicative of true valuation. 

PE Comparison
So far, we have learned about the price-to-earnings (PE) ratio of mutual funds, including its calculation and how it fluctuates over time rather than being a static figure. The PE ratio provides a quick insight into whether a fund is considered expensive or cheap. However, to determine if a fund’s PE ratio is undervalued, overvalued, or fairly valued, it needs to be compared with other funds within the same category. Specifically, Large-Cap funds should be compared with other large-cap funds, not Mid-Cap funds or any other category. Let’s examine the PE ratios of large-cap funds from different asset management companies (AMCs) alongside their respective benchmarks: 

From this analysis, we can see that all the three funds have different PE, and each of them is higher than their benchmark’s PE ratio. Notably, the Kotak Bluechip Fund has the lowest PE among the three, yet it still exceeds its benchmark's PE, indicating that it may be overvalued. Let’s compare the PEs of different categories of funds, as well as the PE ratios of the best performing and least performing funds alongside their benchmark PEs. 

So, basically, here you would have understood how we can compare a fund’s PE with its peers as well as the benchmark PE. We have chosen the best and least performing funds to get an idea of the PE range. Additionally, it is very subjective from person-to-person as to which PE is considered expensive or vice versa but it can be said that if a fund’s PE is greater than the benchmark PE, it may be considered expensive. The PE ratio is dynamic and may change according to the demand in different sectors also. 

Since geopolitical tensions are high and wars are going on in different parts of the world, investors are finding large-cap stocks much more valuable, which could also spike the PE of the large-cap stocks due to demand and the fact that investors are currently willing to pay more compared to the earnings not just due to some hidden potential they have found but due to less volatility in the large-cap stocks as compared to the Small-Cap and mid-cap stocks. 

The average PE of the Nifty 50 index for the last 12 months has been around 22.64. As of October 2024, the current PE is 22.83, not much higher than the average. Last month, in September 2024, the Nifty PE peaked at 24.26, while the lowest PE was recorded in November 2023, at 21.02. You might be wondering why we are covering this market PE here, as we are focused on learning about mutual fund PEs. Well, it is most important to analyse the broader market first before making any investment decisions. With this perspective, we can say that if the market’s PE is at its highest peak, it is advisable not to invest a lump sum but to go through the SIP mode. 

On the other hand, if the Nifty PE is on the lower side, investors can invest funds via lump sum using a pyramiding technique, as PE has a tendency to revert back to the mean. You might also think that checking the market PE is not really important. Well, if you are considering long-term investments, then you might not need to worry, as in the long term, rupee cost averaging benefits and compounding works well. However, in the short term, you should be aware of the market PE when making any investment decisions. 

Limitations of PE Ratio for Mutual Funds
1. Outdated Earnings Data - Mutual funds typically disclose their portfolio holdings on a quarterly or monthly basis and companies typically report their earnings quarterly so that there is often a delay between the end of a quarter and the release of financial results. This lag can affect the EPS figure used by mutual funds and hence the PE ratio. For instance, if a mutual fund’s holdings include a company that reported strong earnings in the latest quarter, but this data has not yet been reflected in the fund’s disclosures, the PE ratio calculated using the outdated EPS may not accurate. 

2. Undervaluation of Growth Companies - For young, growth-focused companies that may have low or negative earnings due to substantial investments, the PE ratio can often understate their long-term value and growth potential. In some cases, companies may even have a negative PE ratio, but if the future growth is promising, the overall PE of a mutual fund can be distorted due to this. Many new companies nowadays are loss-making companies, but the industry or sector may have a promising future. For example, the electric vehicle (EV) sector has a promising future, but the companies that operate in this sector might not be able to generate profit currently. However, when EVs become popular and if the companies improve operationally, their financials would become robust and so will their EPS and the PE. 

3. Inflated PE with Less Growth - It may happen in the market that despite a company having showcased strong growth, the investors could be bullish on the stock, which eventually increases the stock price due to this bullish sentiment, hence boosting the PE manifold. For example, companies like Nykaa or FSN E-Commerce Ventures are currently trading at a PE ratio of 341. Although online shopping is booming and the future of this industry looks promising, this PE ratio appears excessively high relatively. Furthermore, foreign institutional investors (FIIs) and domestic institutional investors (DIIs) include Nykaa’s shares in their portfolios, which likely influence the PE ratio of mutual funds that hold these shares. The extent of this impact depends on the percentage holding or weightage of Nykaa’s stock within those funds. 

4. Manipulation of PE Ratio - The PE ratio of a company can be influenced not only by its price as discussed in the earlier part of the article but also by manipulated financials, a practice known as window dressing, which eventually impacts the mutual fund’s PE. Moreover, fund managers regularly buy and sell stocks from the mutual fund portfolio, which may affect the PE ratio, as reflected from the earlier example. With multiple stocks in a portfolio, frequent transaction in stocks can change the weightage of certain stocks, thereby significantly altering the fund’s overall PE ratio. For instance, selling a stock with a high PE ratio could drastically lower the fund’s PE, even if the broader portfolio remains fundamentally unchanged. 

5. Sector Bias - Sectors that attract significant attention from major investors or media outlets often experience heightened demand, leading to increased PE ratios. For instance, the government’s recent focus on renewable energy, including solar and wind power stocks, has caused PE ratios in this sector to trend upward, with investors willing to pay a premium for stocks relative to their earnings. This inflation in PE ratios can also extend to mutual funds that hold these stocks, resulting in an inflated PE ratio for the funds. Therefore, even if the earnings potential remains stable, the PE ratio of mutual funds can still spike. For example, below is the PE chart of Ujaas Energy Ltd. which undoubtedly grew from 13.30 to 189.71 in just six months. 

6. No Ideal PE Ratio - The PE ratio is not static but dynamic in nature and can change regularly based on the price. It also changes quarterly when the company announces its financials, including the EPS. You might consider a PE ratio of 35 expensive, but others may find it attractive. It varies from person to person. Moreover, while the PE ratio indicates whether an instrument, be it equity or mutual funds, is undervalued or overvalued, it does not precisely define to what extent. The PE ratio is not a definitive rule but rather one of the many factors that can guide investment decisions. 

Conclusion
In conclusion, while the PE ratio can provide some insights into a mutual fund’s valuation, it is not a definitive measure for making investment decisions. The PE of a fund is merely the weighted average of the underlying stocks, and it may not accurately capture growth prospects, cash holdings, or the impact of loss-making companies. Investors should be cautious when interpreting fund PE ratios, as they serve only as a rough guide to the fund’s orientation whether value-driven or growth-focused. 

Instead, the priority should be about identifying funds and fund managers with a consistent track record through various market cycles. Once such funds are shortlisted, the PE ratio can be used to bring diversity in fund selection. Ultimately, a comprehensive evaluation of performance, strategy and management history is more valuable than relying solely on the PE ratio. The PE ratio is not a definitive rule but rather one of the many factors that can guide investment decisions. Furthermore, the PE ratio is a useful tool for comparing mutual funds within the same category, say large-cap funds, mid-cap funds and so on, and in relation to their benchmark indices’ PE ratios. 

It can offer insights into whether a fund leans toward value or growth, helping investors make better comparisons within a category. However, it can be said that you can consider the PE ratio alongside other critical factors such as fund objectives, risk levels, asset allocation and past performance but not in isolation for selecting a fund. As such, it is equally important to understand the role that a mutual fund’s PE may play even if you may not apply it in seclusion for a mutual fund’s selection. A well-rounded evaluation, rather than relying solely on the PE ratio, will lead to more informed and balanced investment decisions. 

Furthermore, each category of funds has a distinct P/E ratio. This means that the P/E ratio of one category does not provide insight into or predict the P/E ratio of another. The P/E ratio serves as a valuation tool, indicating whether an investment instrument, such as equities or mutual funds, is undervalued or overvalued. However, it does not precisely quantify the degree of under or overvaluation. Instead, it helps investors gauge relative value within a particular category. 
 

[EasyDNNnews:PaidContentEnd] [EasyDNNnews:UnPaidContentStart]

[EasyDNNnews:UnPaidContentEnd]