You may have come across the term ‘PE Ratio’ many a time, when you read content on mutual funds or stocks. As an investor, you might find it a tad difficult to evaluate the investing style and approach of the fund manager, only on the basis of the fund portfolio. The PE multiple of a fund is a good reference point for informed decision making.
Mathematically speaking, the PE Ratio or the Price Earnings Ratio is arrived at by dividing the stock’s existing market price by its Earnings Per Share (EPS). This figure shows the price an investor is ready to pay for the earnings delivered by the stock or the company. Let’s say a company XYZ has an EPS of Rs. 100 and the market price of the stock is RS.1000. The PE Ratio, in this case, is a multiple of 10 times, which simply means that the investor is willing to pay a price which is 10 times XYZ’s earning ability.
How is the fair value of this multiple decided in the first place? It is based on many variables like the sector in which the company operates, the business model, the market standing, management, performance; etc. So when you have high quality stock picks with dominant position in the market, sturdy business models and strong earnings capacity, they command high PE multiple. Investors readily buy these stocks, pushing their market price. When we say, the fund manager had adopted a ‘growth oriented approach’, it means that fund manager does not hesitate in paying a high price for stocks that are reflect high profitability.
When one read that the fund manager has used a ‘value conscious approach’ it means he or she is going for the stocks that have low PE Ratio. In this case, the fund manager picks stocks whose prices have gone down in comparison to the fundamental of the company. These stocks obviously, command a considerably low PE Ratio multiple. While growth-oriented funds give high returns in a short frame of time, they are also volatile. Value conscious funds give better results in a long-term period and are volatile to a much lesser degree. Usually, schemes in large cap funds have a higher PE Ratio multiple than the ones in mid cap and small cap mutual funds. But sometimes the momentum in small cap and mid cap can push their PE Ratio to very high and unreasonable levels.
The most common form of PE Ratio is the trailing PE Ratio which is arrived at by dividing the market price of the stock by the earning per share, usually in the past 12 months. But wouldn’t it be a disadvantage to the companies who are turning around after a spate of low performance? Forward PE Ratio takes into consideration the estimated earnings of the company for the next one or two years, based on its potential. However, its very difficult to predict the right forward PE Ratio. Experts have gone wrong many times in making the right prediction.
However, PE Ratio in isolation is not really that useful unless you combine it with average of the category to truly comprehend the investing style of the fund manager. A higher than average PE Ratio of the fund shows that the Manager is going for Growth Play. For instance, let us take a large cap mutual fund with a high PE Ratio of 25 compared to the category average of 19. This means the fund manager is opting for high growth. But at the same time, let’s say the PE Ratio of the Fund is half of the category average. This means the fund manager is going for value play with promising large cap stocks.