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Significance of PE Ratio

Is price-earning ratio for one year or a longer period? If the PE ratio is 18.50, does it mean a mutual fund unit purchased at Rs 10 will yield an earning of Rs 185? -DK Anand

Is price-earning (PE) ratio for one year or a longer period? If the PE ratio is 18.50 does it mean a mutual fund unit purchased at Rs 10 will yield an earning of Rs 185? A fund with a higher price -earning ratio is better performing. Is this correct? Please also explain price-book value ratio.
-DK Anand
The PE ratio is the current price of the stock divided by the reported earning per share of the stock. As a result the PE of a stock is subject to daily change. Since, the future earnings of a company are often built into the price of a stock, the PE ratio signifies to what extent the price is valued at the earning of the share of the past year. It is essentially the price you are willing to pay for Re 1 of a company's earnings. Given that future earnings of a company are uncertain, robust companies are able to extract a premium for their earnings. It has little to do with the returns that a stock could deliver. As a result you cannot use it as a means to forecast future performance, to elucidate further; PE of 18.50 times does not mean that the stock price will essentially grow to 18.50 times. It only means that investors are valuing the stock at 18.50 times of its earnings.

Price to book value ratio (PB) compares a stock's market value to its book value (book value is assets minus liabilities). A lower PB could either mean that the stock is undervalued or that there is something fundamentally wrong with the company. PE and PB are used more as tool for comparison between stocks belonging to a certain peer group as stand alone PE does not signify anything.

As far as mutual fund units are concerned the PE and PB are arrived through a weighted average of the inherent stocks. As a result, you shouldn't assign as much importance to a mutual fund's PE and PB as you would give to a stock's PE. High PE and PB relative to a category would indicate that the mutual fund holds stocks that are currently quoting at a premium and points towards a growth oriented strategy. If you are investing in a value fund, then expect the fund to have a PE lower than that of growth funds.

While short-listing funds going through each funds PE and PB can be quite cumbersome and misleading. To this extent the Value Research Style Box takes care of this problem by presenting a unified snapshot of how a fund's portfolio looks relative to others in its category. This snapshot is a nine-grid matrix, which represents an equity fund in terms of its market capitalisation and valuation.


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