The stock market is a jungle!
However, mutual funds have simplified things to a great extent. This has enabled many new investors to taste equity as an asset class.
But we believe mutual funds have been oversimplified.
For example – PE Ratio is one of the most important factors direct equity investors look at before buying a share. Did you know PE Ratio deeply affects your equity mutual fund investment returns too?
PE Ratio: What is it?
PE Ratio stands for Price-Earnings Ratio.
Mathematically, PE Ratio can represented as follows…
It is a simple ratio which gives you a sense of the value of the share.
Let’s imagine a hypothetical company called XYZ. We know the following things about XYZ –
Number of shares trading: 1,000,000
Earnings of the last 4 quarters: Rs. 10,000,000
Current market price of one share: Rs. 200
So, firstly, earnings of one share of XYZ is calculated as…
This gives us Rs. 10 as the earnings of a share of XYZ.
Now, final step is to calculate the PE Ratio of XYZ as…
So, 20 is the PE Ratio of XYZ.
Types of PE Ratio
There are primarily two types of PE Ratio.
Trailing PE Ratio
Trailing PE Ratio makes use of the last 4 quarters of earnings.
This is also referred to as TTM PE Ratio – Trailing Twelve Months PE Ratio.
Forward PE Ratio
Forward PE Ratio makes use of the next 4 quarters of earnings. Sounds fishy, doesn’t it?
To some extent it is!
Forward PE Ratio tries to predict the earnings of a company basis trends and analysis.
This is the reason TTM PE Ratio is used in most cases to make investment decisions.
NIFTY 50 PE Ratio
An index like NIFTY 50 is just a composition of companies.
This means that NIFTY 50 can have its own PE Ratio. And it will be a representative PE Ratio of the broader market since NIFTY 50 is a representative of the broader market.
Whenever someone says the market is down, he is referring to the NIFTY 50 value that fell sharply.
Additionally, it would be safe to conclude that the market’s valuation is down if NIFTY 50’s PE Ratio is down.
Interpreting PE Ratio
Now that we know what PE Ratio is and how it is calculated, let’s now try to understand what PE Ratio signifies…
In one word… VALUATION
If the PE Ratio of NIFTY 50 is low when compared to historical levels, you can say that the NIFTY 50 is undervalued.
On the other hand, if the PE Ratio of NIFTY 50 is high when compared to historical levels, you can say that the NIFTY 50 is overvalued.
What valuation you think is more favourable for an investor?
We can think of this using an analogy.
Let’s say you are at your local market and there are three shops.
Shop 1 sells an apple at Rs. 10. Great, juicy red apples.
Shop 2 sells an apple at Rs. 15. Quality similar to shop 1’s apples.
Shop 3 sells an apple at Rs. 10. The quality is not up to the mark.
Where are you likely to buy your apples from?
From shop 1, I hope. Any other answer and you need grocery training!
Why did you shop from shop 1? Because it was selling great apples at a low cost – it offered value.
You buy something only when you see value.
Value can be thought of as an attribute that depends up on the price of something and its utility to you. If the utility is higher than the price, then it’s good value!
Similarly, it has been observed that low PE Ratio of NIFTY 50 indicates great value to investors. A low PE Ratio is a great entry point for equity investors.
And conversely, a high PE Ratio indicates a poor value for equity investments.
NIFTY 50 PE Ratio History
We can make a few important conclusions after observing trends in the NIFTY 50 PE Ratio historical values.
Here’s a chart that will help us do so…
- 2 out of 3 times when the PE Ratio has breached the 28-mark, there have been financial crises. These financial crises saw the market fall by greater than 50% both the times.
- At lower PE levels like 10-16, the market tends to rebound into a sustained bull run.
And there are many other conclusions that can be drawn basis this single chart. All of them can be used to design intelligent mutual fund investment strategies.
How does PE Ratio affect your mutual fund investment returns?
This gets interesting!
PE Ratio has been traditionally used to take only direct equity investment decisions. Seldom have investors taken a mutual fund investment decision basis PE Ratios.
We conducted a quick research to check how PE Ratio can affect your mutual fund investment returns.
So, we are going to be using the following –
- NIFTY 50 TTM PE Ratio
- NAV of ICICI Prudential Value Discovery Fund – Regular – Growth (a multi-cap fund started in 2004)
We are going to compute returns in this fund at different PE Ratios. Further, we shall compute the returns for different investment periods as well…
There is a clear trend we can see here.
Irrespective of the investment period, investments made at lower PE levels (17 and less) always do better than investments made at higher PE levels (21 and greater).
So, an undervalued market could be considered as favourable for equity mutual fund investments.
And the converse is also true – overvalued market is unfavourable for equity mutual fund investments. So, it is best to stay away from equity mutual funds when the market is overvalued.
We can see this across multiple equity mutual funds across multiple categories.