PE Ratio Explained
What do we infer from a higher PE ratio and a lower PE ratio and which one is better?
- J Banerjee
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. Because of this relation with a company's profits, this ratio is also called the earning multiple. For a company, a PE ratio tells you how much investors are willing to pay for one rupee of its earnings (profits).
Some shares have higher PE ratio and some lower. A 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 in profits. These stocks are often referred to as growth stocks.
At the other end are the 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.
As regards mutual funds, first of all, an equity fund is a collection of shares. Therefore, a fund's PE is the average of the PEs of all the 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 PEs 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 generally have lower PEs than large-cap funds. Hence, a fund's PE ratio can tell us whether the fund has more growth stocks or value stocks compared to another fund. But remember, just as growth and value are not static concepts, the PE of a fund also will change.
A price earning ratio is not good or bad in itself. It has to be seen vis-a-vis various factors. For example, as we have mentioned earlier, a higher PE indicates expectations of faster growth of profits. Therefore, it would seem that such a stock is a good bet. But actually, the truth might be that the expectations are irrationally high and the stock is not worth the price it is commanding at the moment. Such a stock can become the recipe for disaster.
On the other hand, while picking a low PE stock, one has to ensure that it is fundamentally a good company and the price earning ratio is low either because the stock has not yet caught the attention of the market at large or is out of favour at present, or it happens to be a low-growth but very stable company and you are banking upon the higher and consistent dividend income from the stock.
Should I Invest in Equities?
I am new to the stock market. My mother wants to park her Rs 10 lakh in post office schemes, like the Monthly Income Scheme. But I think trying the market will be a good idea. I am a student and haven't yet got a job. Is it fine to invest at least Rs 1 lakh in stocks or equity funds, if we do not have any other source of income right now. What should I do?
If you do not have any other source of income, investing in equity funds could be a risky move. When the markets crash, you could easily be looking at a short-term loss of 20 per cent or so, even in good funds. Are you sure this is acceptable?
The first thing that you should do is invest in the post office monthly income scheme. It earns an interest of 8 per cent and at the end of the term, there is a 10 per cent bonus. The effective returns from this scheme work out 9.1 per cent, which is excellent. But this deposit comes with a ceiling of Rs 3 lakh in single name or Rs 6 lakh in a joint name. We suggest you invest Rs 6 lakh in this scheme.
You could look at investing Rs 3 lakh in other safe savings options like Public Provident Fund, National Savings Certificates or bank fixed deposits. You could invest a substantial portion of the Rs 1 lakh in a monthly income plan, which invests about 80-90 per cent of the money in bonds and the rest in equities, which will provide you safety and some upside from the stocks portfolio. You could look at Prudential ICICI MIP and FT India MIP here.
If you want to take an equity exposure then we suggest a balanced fund like HDFC Prudence, which invests up to 70 per cent in equities and the rest in safer debt instruments.
If you still have some money left then we would recommend a large-cap fund which is likely to fall less than other equity funds in case the market falls. Franklin India Prima Plus is one such fund you could look at.
Going by your query, we have come to understand that safety is paramount and that you want to protect the Rs 9 lakh as well as you can. With the MIP and balanced fund, a substantial portion of the Rs 1 lakh will be safe. And you get to learn about equity investments too. When you start working and have your own money, you will be able to take more risks. Good luck.
How Do AMCs Charge Tax?
Mutual funds are subject to various taxes--dividend distribution tax, capital gains tax and securities transaction tax. How will the fund houses charge these taxes to the returns which the fund makes?
- N Rajesh
Let's look at the taxes that you have mentioned individually.
Dividend Distribution Tax: As the name suggests, this is a tax that is levied as and when the fund declares a dividend. However, only the debt-oriented funds have to pay the dividend distribution tax while the equity ones are exempt from it. The quantum of tax is 14.025 per cent of the amount of dividend (12.5 per cent tax + 10 per cent surcharge + 2 per cent cess). This tax is deducted by the fund house at the time of making the dividend payment. Often the funds declare a gross dividend and a net dividend. Gross dividend is the amount which is deducted from the corpus of the fund, while the net dividend is what an investor gets net of tax from this gross dividend. The ex-dividend net asset value (NAV) of the fund is declared after factoring in the dividend distribution tax.
Capital Gains Tax: Capital gains tax is not charged by the fund house. It is paid by the investor directly to the tax authorities while filing the income tax return. Moreover, any capital gains arising from the equity oriented funds are exempt from tax if your holding period exceeds one year.
Securities Transaction Tax: Equity-oriented mutual funds are subject to securities transaction tax (STT) at the rate of 0.2 per cent at the time of selling the fund units. This charge is deducted when you redeem your investments.
Investing with a Target
I am a 30-year-old, married software professional and planning to invest Rs 5,000 every month in diversified equity and ELSS funds through SIP. I have already invested in HDFC Long-Term Advantage and Reliance Tax Saver funds. My primary aim is to build an asset base of around Rs 25 to 30 lakh in the next 10 to 15 years. Is it achievable? How should I allocate my portfolio so that I can achieve my target and form a balanced portfolio? Do I need to allocate some percentage of my portfolio to debt funds?
- Satish M
You would need an annualised return of about 12.6 per cent to accumulate a corpus of Rs 25 lakh after 15 years by investing Rs 5,000 per month throughout this period. If we go by the past performance of some of the older diversified equity funds, then it should not be a problem to achieve that much of returns. Even though past performance can never be taken as a guarantee, your target still looks quite achievable. Here is the reason. A fixed deposit with a nationalised bank can give you returns of around 6 per cent, which can be considered as a risk-free rate. If we add a risk premium of 100 per cent for the equities over this, the return comes to 12 per cent, which is close to the return that you require. Though nothing can be said with certainty, maintaining discipline by not losing your cool during the bull runs and as well as the extreme bear phases is more likely to ensure that you achieve your target.
Given your time horizon of investment and your targeted returns, you can maintain an all equity portfolio. Please note that it is bound to be more volatile than it would be if you invest in debt funds also, but investing regularly over such a long term should ensure that you earn handsome returns despite the ups and downs of the market.
Select a few good diversified equity and ELSS funds for your portfolio. But you must keep a track of your funds regularly. If any of your funds starts to underperform on a consistent basis, you might need to look for other options in the same categories. A simple way could be to choose from the five- and four-star rated funds. If the rating of any of your funds drops to three-star, keep a close track of it for the next few months. And if it falls further to two- or one-star, consider exiting the fund for some better options. One issue that we hope you have considered is inflation. It is likely that what Rs 25 lakh can buy today will need Rs 50 lakh to buy 15 years later (at an inflation rate of 5 per cent). Do take this into account while setting your target.
Perception of Investors
Why don't people see mutual funds as lucrative investment products?
- Rahul Jain
Mutual funds are still not the first choice of most Indians when it comes to investing. The foremost reason for this is the availability of government backed savings instruments that offer a high rate of assured returns.
Not only do instruments like National Savings Certificate and Public Provident Fund guarantee a high rate of interest, but they also come with the backing of the central government, thus assuring capital safety of the highest order. Moreover, such instruments come with powerful tax saving incentives.
High returns, coupled with the risk-averse mentality of the average middle-class - which constitutes majority of our population - have kept the bulk of savings away from mutual funds. Long-term savings find their way into instruments like National Savings Certificate and Public Provident Fund, while bank fixed deposits are preferred for short-term investments.
Mutual funds are also plagued by the lack of penetration across the country which stops them from tapping the savings potential of smaller towns.
However, certain developments in recent years have been encouraging for the mutual funds industry. First, the rates of return offered by the assured return instruments have come down significantly, forcing people to look beyond them.
Second, the mutual fund industry has become more transparent in terms of disclosures. Third, the ELSS category of funds has come at par with other instruments in terms of tax saving incentives. These developments are likely to attract more people towards mutual funds.
Ensuring Child's Future
I have one child for whom I want to invest. Which is the best investment category that can give me promising returns? I am 25 years old and my investment horizon is around 30 years.
- Chirag Gheewala
Given your long-term horizon, you would be advised to invest in equity funds at present. There are two reasons why equities will be the most suitable asset-class for you.
First, 30 years is a long enough time horizon, and if you keep investing in good diversified equity funds systematically, the chances of you incurring a loss will get substantially reduced. Second, equities have the potential to generate the kind of returns that will help you to accumulate sizeable amount of money to meet future needs of your child, like education.
But there are few things that you must remember. Historically, equities have proved to be the best asset class over a long term horizon. At the same time, they tend to be the most volatile in the short term. Therefore, you should turn a deaf year to the ups and downs that the equity markets may witness over the period of time.
Also, do not get carried away by a rally in the stock market so as to invest huge amounts at one go. As mentioned earlier, markets remain volatile and repeatedly pass through bear and bull phases. But it would be better if you stay away from greed to make quick bucks by investing large amounts at a time. Maintaining focus on your long-term goal will help you succeed.
You must not be too casual to keep investing without reviewing your portfolio. Over a period of time, many things can happen which may require you to re-consider the investment decisions you had taken earlier.
There can be instances where the good looking funds become bad as a result of various factors, like change in the management style, or the investment objective etc.
Therefore, you must review your portfolio intermittently to make sure that things are in place on the investment front.
Moreover, we think that a lock-in period of three years should not be a problem for you. Therefore, investing in tax-planning funds will also make a lot of sense in your case.
ELSS funds resemble diversified equity funds in the way they invest, the only differences being that they come with a lock-in period of three years, and offer tax exemption under Section 80C of the Income Tax Act, which makes a strong case for them. These funds have performed better than diversified equity funds, as the former have a longer term horizon, which suits you.
Lastly, if you think that an all-equity portfolio will be too volatile for you, then you can consider adding a good balanced fund. However, we believe that equities should still dominate this portfolio right now. As you approach the time when you would be requiring funds, start increasing the debt portion of the portfolio, to safeguard against negative surprises that equity markets may throw up at the time of redemption.
PE Ratio Explained