If you are an existing or potential mutual fund investor, it always helps to dig deeper into a fund’s details such as its financial ratios. One such important ratio to keep an eye on is the P/E ratio or Price to Earnings Ratio.
To understand what the P/E ratio means for mutual funds, we must first understand it in terms of a stock. Price to Earnings ratio is the market value of a stock divided by its earnings per share. It is also known as ‘price multiple’ or ‘earnings multiple’. It can hence be viewed as a measure of how much investors are willing to pay for a stock compared to its earnings. P/E Ratio = Price Per Share / Earnings Per Share
This means that if the P/E of a stock is very high compared to its peers, it is seen as an overvalued stock. Similarly, if the stock’s P/E is lower than its peers, it is seen as an undervalued stock. While there are many other fundamental factors that could be at play, P/E can be referred to as an important indicator of valuation.
Since a mutual fund includes a number of stocks, the fund’s P/E ratio is calculated by taking the weighted average P/E of all its underlying stocks in proportion of their holding percentages. Since this is an averaged out number, it can be hard to gauge if it is of much significance when picking a mutual fund. Yet, you can keep an eye out for exorbitantly high or low P/E numbers and make your investment decision accordingly.
It is important to note that just because a stock has a high P/E, it does not make it a risky investment by itself. This is because there are many stocks in a phase of growth due to which investors find it worthwhile to invest in them even if their P/E ratio is high. Similarly, a low P/E ratio stock may not always mean a good investment as there could be something fundamentally flawed in the company which the investors have taken notice of. Generally speaking, the P/E ratio of Nifty stocks have varied between ~10 and ~30 ,with the index average at around ~20 over the last decade.
It is also important to check what type of P/E ratio is given. Some investors refer to Absolute P/E whereas others refer to the Relative P/E. There is also the Trailing Twelve Month P/E ratio and Forward P/E ratio which can be useful to market observers. Hence, the P/E ratio is a useful indicator but must not be followed blindly while making investment calls. It must be used as one of several indicators.
Just like the P/E ratio, there are many other important indicators available for investors to check and make their investment decisions. It is important to understand these before beginning your investment journey. You can learn more about the same here. Now you can also open a demat account online at the click of a button to begin your investment journey.