PE & PB of mutual funds
Many market experts believe that the current rise in the equity market has made its valuation quite stretched and expensive from a historical perspective. There are primarily two valuation ratios used to gauge the attractiveness of the market overall and individual stocks. When it comes to stock selection, the price-to-earning (PE) and price-to-book (PB) ratios do have relevance as they are some of the most crucial valuation metrics.
Nevertheless, extending the same logic in selecting funds based on these two metrics may not lead you to a profitable decision. This is because the PE and PB multiple of the scheme is calculated by using a weighted average of underlying stocks that form part of the fund’s portfolio in proportion to their allocation in the portfolio.
A fund with higher PE and PB may have been following a growth style of investment, which in most cases, will invest in companies with higher PE & PB and reflect in the overall higher PE as well as PB of the fund. On the contrary, a fund with lower PE and PB signifies a value-conscious approach of the fund. Here, the fund manager is more comfortable looking for stocks that are currently out of favour or where the stock price has been beaten down disproportionately to the fundamentals of the company.
Therefore, it makes no sense to look at a fund’s PE or PB ratio to take any decision. However, this can prove to be relevant in the case of index funds but again, that is more like timing your investment, which may not be a prudent way to approach mutual fund investment. At the most, an investor can use is it as one of the criteria to analyse the funds if he is looking at similar kinds of funds. So, if the PE of a fund following growth style is lower than other funds following the same style it may be attractive if the quality of the portfolio remains strong.