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Fund's PE Ratio

While the price-to-earnings ratio is an important number for equity investors, mutual fund investors should use this with caution. PE ratio of a fund doesn't indicate what a PE ratio of stock indicates.

PE is the Holy Grail for equity investors. As an equity fund investor, how much importance should you give to this? Well, the answer is that you shouldn't assign as much importance as you would give to a stock's PE. Let's see why. For a company, a PE ratio tells you how much investors are willing to pay for one rupee of its earnings (profits). This can be seen from the definition of PE ratio. It is the ratio of the share price of a company to its earnings per share (EPS). EPS is the profit that a company makes on a per share basis. So, if EPS is one, the PE ratio will reflect the price that an investor will pay for this one rupee of the company's profits. Because of this relation with a company's profits this ratio is also called the earning multiple.

Some shares have higher PE ratio and some lower. Higher PE ratio signifies that investor expectation from these shares is higher. This is because the growth in share price is expected to follow earnings growth. So, if investors are willing to pay more for a share, it is because they are expecting faster growth of profits. These stocks are often referred to as growth stocks.

At the other end are companies which have a low earnings multiple. Here, investors are not expecting much growth, and these stocks are called value stocks. The situation could change as a company that has been growing slowly can gather pace and a fast-mover can slow down. Growth and value are thus not static concepts.

What about funds? Well, first of all, an equity fund is a collection of shares. Therefore, a fund's PE is the average of the PEs of all stocks, in proportion to their presence in the portfolio. Because fund portfolios change, the PE will also change and this will not reflect the growth prospects of the underlying assets. A fund's PE is the weighted average PE of its stocks. Cash has no role to play. Thus, caution has to be exercised and the cash component has also to be factored in while looking at PEs. Similarly loss-making companies are assigned a zero value. For these reasons, a fund's PE is not as relevant as that of a share.

Nonetheless a fund's PE can be used for comparing funds in its category, or in comparing categories. If you are investing in a value fund, then expect the fund to have a PE lower than that of growth funds. Similarly, mid-cap funds will have lower PEs than large-cap funds. Thus, the three mid-cap funds, Birla Midcap, Franklin India Prima and Sundaram Select Midcap, had PEs of 10.83, 8.57 and 6.79, as on May 31, 2003. In comparison, the Sensex, which comprises 30 large-cap stocks, has a PE of 13.25.

Technology funds, on the other hand, have higher PEs, as technology stocks have high PEs vis-a-vis other stocks. Within this, the PE can be used to discern the stock selection of the fund manager. Thus, Franklin Infotech Fund—which strongly favours large and well-established technology companies—has always had one of the highest PEs in the technology fund category. Funds such as Birla IT have seen greater variation in their earnings multiple as they have moved between large and mid-cap IT stocks.

Just as growth and value are not static concepts, the PE of a fund also will change. Thus, Magnum Contra, a value fund had a PE of 8.84 in April 2000. Today, as the value has been unlocked from many of its shares, the fund sports a higher PE of 11.44.

Hence, a fund's PE ratio can tell us whether the fund has more growth stocks or value stocks compared to another fund. However, one has to remember that the PE ratio for different fund categories can vary widely, and it can change from high (growth) to low (value) or vice-versa. In all, a fund's PE is a helpful comparative tool, but it must be made use of with caution.