What do the P/E and P/B ratios, shown in your scoreboard tables, tell us about a fund's portfolio?
-Vinay Kala
Both these variables are used in great detail by stock investors. Generally, a stock P/E (price-to-earnings ratio) tells us how much investors are willing to pay for one rupee of that company's earnings. Higher P/E signifies that expectations from these shares is higher - these stocks are often referred to as growth stocks. But a fund's P/E is the average of the P/Es of all stocks in proportion to their presence in the portfolio. This, however, does not consider fund's cash component. Similarly, loss-making companies are assigned a zero value. For these reasons, a fund's P/E is not as relevant as that of a share.
On the other hand, P/B (price-to-book value ratio) is used to compare a stock's market value to its book value (book value = assets minus liabilities). A lower P/B could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. A fund's P/B is calculated on similar lines as P/E, i.e. the weighted average P/B of all the stocks in the fund's portfolio. Here too it does not take care of cash.
Nonetheless, a fund's P/E and P/B 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 low P/E and P/B than that of growth funds. Similarly, mid-cap funds will have relatively lower ratios than large-cap funds. For example, Franklin India Prima had a P/E of 12.06 and P/B of 2.79, whereas the large-cap Franklin India Index BSE Sensex fund had the P/E of 16.89 and P/B of 4.56, as on July 31, 2004.
Technology funds, on the other hand, have higher P/Es and P/Bs. Within this, these ratios 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 P/Es and P/Bs in the technology funds' category. Funds such as Alliance New Millenium have seen greater variation in their earnings multiple as they have moved between large and mid-cap IT stocks.
Hence, a fund's P/E and P/B can tell us whether the fund has more growth stocks or value stocks compared to another fund. However, one has to remember that these ratios 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 P/E and P/B are helpful comparative tools, but they must be made use of with caution.
This article was originally published on September 28, 2004.
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