When investing, most people only focus on earnings. While earnings are a critical component to assess in an investment, the price at which the security offers the stated earnings is equally essential. In the world of mutual funds, particularly equity mutual funds, analyzing the cost and earnings of investment is vital. This is also known as the PE (Price to Earnings) ratio in a mutual fund scheme. The PE ratio indicates the price payable for one unit of a stock’s earnings. PE ratio has a direct bearing on the mutual fund investment returns.
Here are some ways that state how a PE ratio impacts mutual fund investment returns:
What is a PE ratio?
The price to earnings ratio (PE ratio) measures the market price of a company’s share relative to its earnings per share (EPS). The percentage signifies the amount an investor is willing to pay to get one unit of stock earnings. A high PE ratio means the stock is overvalued or growing and can generate high profits. Alternatively, a low PE ratio indicates the company is undervalued and might perform poorly in the future.
A PE ratio is the weighted average of all stocks in the portfolio in mutual funds. Mutual funds that follow a growth investing style have a high PE ratio. Alternatively, mutual funds with a low or moderate PE ratio follow a value-oriented or contrarian investing style.
How does a PE ratio impact mutual fund investment returns?
Returns from a mutual fund scheme depend on the fund manager’s portfolio composition and investment strategy. In such circumstances, the PE ratio proves effective. But it isn’t easy to ascertain the investment style and preferences of the fund manager by simply looking at the mutual fund portfolio.
The PE ratio of a mutual fund is the average PE of the underlying stocks of the portfolio in proportion to their portfolio allocation. A high PE ratio of a mutual fund indicates the scheme contains stores with a valuation premium and follows a growth-oriented strategy. The fund manager focuses on earning profits in the growth approach even if the stock comes at a slightly high price.
Alternatively, if the PE of a mutual fund is low, it indicates that the mutual fund manager follows a more value-oriented investment strategy. In this portfolio, the fund manager is more inclined to choose stocks with solid fundamentals even if their current market value is unfavorable.
A growth-oriented mutual fund scheme might exhibit high returns quickly but is subject to high market volatility. However, value-conscious mutual funds might not generate high returns in the present but will potentially yield high and stable returns in the long run. These mutual funds are less volatile than growth mutual funds. To further reduce your risk and improve returns, you can use the SIP (systematic investment plan) mode to invest in a mutual fund scheme of your choice.
Overall, the PE ratio significantly impacts the mutual fund investment returns. However, it is not wise to make decisions alone based on the PE ratio. As an intelligent investor, use the Tata Capital Moneyfy app to compare mutual fund schemes in various important parameters and assess their return over the years to make an informed decision.