PE Ratio: Meaning, Types & How to Calculate for Mutual Funds
4 June, 2025
Synopsis
The PE Ratio estimates mutual fund worth by comparing stock prices against earnings statistics to identify price overvaluation or undervaluation.
There are two types: Trailing PE, which is based on past earnings, and Forward PE, which is based on expected future earnings of the company’s stock, helping investors assess growth potential.
A high PE Ratio indicates growth potential but higher risk, while a low PE suggests stability with slower returns, making it key for smart investment choices.
Suppose you are purchasing a smartphone under a budget of ₹30,000. The shopkeeper had shown you three models under the range, but you are confused because all three smartphones look the best. You must be thinking about how you can choose the best out of those three smartphones. Then, you decided to compare the features and performance of the smartphones. Similarly, investors use the PE Ratio to compare the mutual funds, ensuring they invest in funds that offer the best value relative to earnings.
What is the PE Ratio in Mutual Fund?
PE Ratio stands for Price-to-Earnings Ratio. It refers to the relationship between the price of the company’s shares and its earnings per share. When the PE Ratio is less, then the company is considered to be undervalued. In contrast, if the PE Ratio is higher, the company is valued in the market at higher valuation multiples. Investors can use the PE ratio of different companies to compare their valuations. A higher PE Ratio indicates that investors are willing to pay more for each unit of earnings of a particular stock.
The formula to calculate the PE Ratio is:
PE Ratio = (Current Market Price of a Share / Earnings per Share)
Types of PE Ratio
There are mainly two types of PE Ratio and are discussed below:
Trailing PE Ratio
Trailing PE Ratio is the common metric used by investors where past performance earnings of a company over a period of time are considered. Trailing the PE Ratio helps investors check the past record of the company’s shares and helps them make an informed decision.
Forward PE Ratio
It is calculated by the price of the single unit of the stock of a company and its expected earnings over a period of time. This ratio is highly based on the future earnings of the companies, which helps the investors assess how a company is expected to perform in the future and its estimated growth.
How do you calculate the PE ratio?
Finding the PE ratio for the individual stocks is straightforward, as it just needs the current market price and EPS of the stock. However, for the mutual fund, it is more complex because these funds hold multiple stocks. To determine the PE ratio, you need to:
Firstly, you need to identify the individual stocks held by the mutual funds.
Then, find the market price and trailing 12-month EPS for each of the stocks.
Calculate the PE ratio for each stock.
Take the weighted average of the PE ratios of the individual stocks.
This weighted average PE ratio provides 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 40% of its portfolio in Stock A with a PE ratio of 20 and the other 60% in Stock B with a PE of 15. To calculate the overall PE of the fund, we assign weights to the individual PEs based on the stock allocation.
So, 40% of 20 is 8, and 60% of 15 is 9. By finding the two weighted ratios, you will get an overall PE of 17 for the mutual funds. After finding out the PE ratio of the mutual fund, you can now compare it with the benchmark. If the PE ratio is above the benchmark, it can be a good investment choice.
Why is the PE Ratio Important for Mutual Fund Investors?
Mutual fund investors should focus on the PE ratio due to its importance in their investment decisions. Some of the key factors for calculating the PE ratio are discussed-
- Valuation Indicator: The PE ratio helps investors determine both overpricing and under-pricing issues with mutual fund investments.
- Market Sentiment Analysis: An increasing PE ratio may reflect bullish market sentiment, whereas decreasing PE ratios could suggest pessimism.
- Risk Assessment: The PE ratio of mutual funds suggests high-risk/high-growth potential in higher PE ratios, while the lower PE ratios offer stability through slower performance.
- Comparative Analysis: Investors can compare the PE ratio of different mutual funds to choose the one that suits their risk appetite and investment objectives.
A PE ratio in mutual fund assessment reveals how accurately investors value the fund by determining its true value against its market price. A high PE ratio shows potential growth but exposes investors to increased risk levels, whereas a low PE ratio provides less risk and slower investment returns. The utilisation of the PE ratio requires analysis with multiple financial metrics as well as market conditions and investment objectives to determine investment decisions. Strategic decision-making through well-rounded methods leads to better investment profits.
Limitations of the PE Ratio in Mutual Funds
While the PE Ratio helps assess mutual fund valuation, it has a few limitations:
Based on Estimates: Even though Forward PE tries to predict future earnings, the number is still based on estimates and assumptions. These future earnings can change due to market volatility, industry disruptions, or economic shifts. So, if expectations don’t match reality, the PE Ratio can be misleading.
Sector Differences: High-growth sectors naturally have higher PEs, so comparing funds without context can mislead.
Not Useful for Loss-Making Companies: If a stock has negative or very low earnings, its PE becomes unreliable.
Ignores Other Key Factors: It doesn’t consider fund manager expertise, diversification, or past performance.
Can Be Skewed: Mutual funds often have concentrated holdings in a few major stocks. If one or two of these companies have extremely high or low PE ratios, they can significantly impact the fund’s overall PE, making it less reliable for comparison.
It's important to note that while the PE ratio is a valuable tool, it should not be used as a single parameter for evaluation. Investors should consider other metrics and factors, such as the fund's performance history, expense ratio, holdings, and overall investment strategy, to make informed decisions.
Through the HDFC Bank SmartWealth App, you can gain access to expert financial analysis as well as fund recommendations that suit your risk appetite, which will help you optimise your portfolio. Security of your financial future begins today. Download the App now!
Disclaimer: This communication has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. HDFC Bank Limited ("HDFC Bank") does not warrant its completeness and accuracy. This information is not intended as an offer or solicitation for the purchase or sale of any financial instrument / units of Mutual Fund. Recipients of this information should rely on their own investigations and take their own professional advice. Neither HDFC Bank nor any of its employees shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information contained in this material. HDFC Bank and its affiliates, officers, directors, key managerial persons and employees, including persons involved in the preparation or issuance of this material may, from time to time, have investments / positions in Mutual Funds / schemes referred in the document. HDFC Bank may at any time solicit or provide commercial banking, credit or other services to the Mutual Funds / AMCs referred to herein.
Accordingly, information may be available to HDFC Bank, which is not reflected in this material, and HDFC Bank may have acted upon or used the information prior to, or immediately following its publication. HDFC Bank neither guarantees nor makes any representations or warranties, express or implied, with respect to the fairness, correctness, accuracy, adequacy, reasonableness, viability for any particular purpose or completeness of the information and views. Further, HDFC Bank disclaims all liability in relation to use of data or information used in this report which is sourced from third parties.
HDFC Bank is an AMFI-registered Mutual Fund Distributor & a Corporate Agent for Insurance products.
Video
