The PE ratio gives you an idea of how much you are paying for each rupee of earnings generated by the stocks held within a mutual fund. In simple terms, the PE ratio shows the relationship between the share price of the stocks in a fund and the earnings per share generated by those stocks.

Let’s understand the PE ratio of mutual funds further:

What is the PE Ratio?

The price-earnings ratio basically tells you how much an investor is paying per rupee of earnings generated by the stocks within a mutual fund.

For example, a PE ratio of 20 means the investor is paying Rs 20 for every Rs 1 of earnings per share. Simple enough?

Now, how do we actually calculate this PE ratio for a mutual fund? Well, it's not as straightforward as calculating it for a single stock.

A mutual fund contains many different stocks in its portfolio. So, we have to take into account the PE ratios of the individual stocks and then take a weighted average based on their proportion in the fund.

How to Calculate the PE Ratio for Mutual Funds?

For individual stocks, calculating the PE ratio mutual fund is straightforward, as we just need the current market price and EPS. However, for a mutual fund, it is more complex as a typical fund holds dozens of different stocks.

To determine the PE ratio of a mutual fund, you need to:

1. Identify the individual stocks held by the mutual fund

2. Find the market price and trailing 12-month EPS for each of the stocks

3. Calculate the PE ratio for each stock

4. Take the weighted average of the PE ratios of the individual stocks

This weighted average PE ratio gives you the overall PE ratio for the mutual fund. The weight assigned is the proportion of the value that the stock represents in the overall portfolio.

Suppose a mutual fund has 50% of its portfolio in Stock A with a PE ratio of 15 and the other 50% in Stock B with a PE of 20.

To calculate the overall PE of the fund, we assign weights to the individual PEs based on the stock allocation.

So, 50% of 15 (which is 7.5) and 50% of 20 (which is 10).

Add the two weighted ratios, and we will get an overall PE of 17.5 for the mutual fund.

Now that we know how to calculate it, what does this PE ratio tell us?

Well, it gives us a quick idea of how expensive or cheap the underlying stocks are valued relative to their earnings.

A high PE suggests investors are bullish on future growth, while a low PE indicates the stocks are available at a bargain.

What Does the Mutual Fund PE Ratio Tell You?

The mutual fund PE ratio gives investors an idea of how cheap or expensive the underlying stocks in a mutual fund are trading at. Here are some things to keep in mind:

1. Growth funds tend to have higher PEs than value funds. That makes sense, right? Since growth is expected.

2. Compare the PE to the category average. For example, if a large-cap fund has a PE way above its peer average, it's a sign of overvaluation.

3. If the PE is rising over time, it means investors are paying more for the same earnings. Not necessarily bad, but worth digging into.

4. Along with PE, also look at price-to-book ratio, dividend yield etc. to get a holistic sense of valuation.

What is a Good PE Ratio for Mutual Funds?

There is no one optimum PE ratio for mutual funds. A good PE ratio depends on the category and investment style of the mutual fund.

Here are some thumb rules:

1. Large-cap funds - A PE between 17-22 is considered reasonable for large-cap mutual funds. Above 22 indicates possible overvaluation.

2. Multi cap/Flexi cap funds - These funds tend to have a higher PE in the range of 19-26 due to a mix of large, mid and small-cap stocks.

3. Mid-cap funds - Mid-cap funds tend to trade at a premium due to high growth potential, so a PE between 20-30 is common. Above 30 may be a cause of concern.

4. Small-cap funds - These funds invest in emerging companies and tend to have high valuations with PE ratios in the 25-50 range.

Remember that the PE ratio must be seen in the context of the market conditions, category averages and expected earnings growth rate.

Limitations of PE Ratio for Mutual Funds

While PE ratio is an important metric, it does have some drawbacks when applied to mutual funds:

1. The earnings data may not be current. Mutual funds disclose holdings periodically, so EPS could be outdated.

2. It does not account for future earnings growth which is a key factor in stock valuation.

3. It can understate the value of loss-making or young growth-focused companies which invest heavily for growth.

4. Sector trends can skew PE for sectoral or thematic funds. For example, traditionally, technology stocks tend to have a higher PE.

5. The ratio can vary widely across stocks in a diversified fund, making the weighted average less meaningful.

So, the PE ratio should not be viewed as the sole indicator of a mutual fund's valuation. It needs to be supplemented with other parameters like PEG ratio, price to book value, debt levels, revenue growth, etc., to get the complete picture.

Conclusion

In summary, the price-earnings ratio gives investors a quick way to gauge how expensive the basket of stocks within a mutual fund is trading relative to their earnings. While higher PE indicates growth expectations, extremely high ratios could signal overvaluation and heightened downside risks. The PE multiple must be seen in the context of the market, category averages, earnings growth rates and other stock valuation parameters to properly assess a mutual fund. It provides an important data point for evaluating mutual fund investments but should not be the only criteria driving investment decisions.