One of the most remarkable ways to build wealth is to invest in businesses, real estate, stocks, mutual funds, and bonds, which can continue to generate income for you daily, weekly, and monthly. However, one must note that generating earnings is only a piece of the puzzle. What is more important is to know how much we are paying to acquire this income-generating asset, which means we must be aware of the price and the earnings, both.

In this blog, we will tell you about the ratio, which tells you just that, and how you can use it to improve your mutual fund portfolio’s returns.

**Understanding PE Ratio**

The Price-to-Earning Ratio or the PE Ratio is a method of valuing a business based on its profits.

For example, Suppose you own a bookstore, which earns you an annual profit of Rs. 5 lakh. Now, suppose that another business owner offers you a price of Rs. 40 lakh to buy the bookstore. This means that your book store’s value that is currently earning 5 lakhs in annual profits is Rs. 40 lakh. Upon dividing this price by the profit (40 lakh divided by 5 lakh), you get a PE ratio of 8. This means that you are being offered Rs. 8 for Re. 1 of the profits earned on your bookstore.

Similarly, let’s look at another example where you own an apartment and give it out on rent. Assuming that you purchased the apartment for Rs. 1 crore and receive Rs. 4 lakh as annual rent, then your investment has a PE ratio of 25.

**Why is PE Ratio important?**

The PE Ratio is the most commonly used valuation metric when it comes to investing. This ratio acts as a thumb rule on determining the amount that should be paid for any investment, whether it is a stock, a specific sector, or broader indices like the NIFTY 50 or SENSEX.

To understand the role of PE ratio in broader indices like the NIFTY 50, let’s look at an example-

NIFTY 50 is a broad market index derived from India’s top 50 listed companies’ market capitalization. Let’s look at the data of 20 years of NIFTY 50.

In the above graph, we can see that in January 1999, the NIFTY was at 966 points, and today has grown by over 11 times to 11,248 points at the end of September 2020. This can be referred to as the price. The other line is of net profits or earnings of the NIFTY companies, which generally follow an upward trajectory barring a deep fall in the 2nd quarter of 2020 due to the coronavirus pandemic. By dividing these two, we get the PE ratio.

However, it is essential to note that the PE ratio never remains constant. This is because the stock prices and the earnings keep changing.

It is better to understand the PE ratio’s high and low values by drawing a line in the middle. This line represents the average price-to-earnings ratio of the NIFTY 50 over two decades, which comes out to be 20.

This implies that the PE ratio from 2011 to 2013 was well below the long-term average, which effectively means that investors were undervaluing the NIFTY. In other words, investors were ready to pay 16 to 18 rupees per 1 rupee of profit. The exact opposite is what we see for the last 3 years from 2017, where the NIFTY PE is in an over-valuation zone with investors paying 26 to 28 rupees for every rupee of net profit.

It must be noted that there is a multitude of factors ranging from current earnings, future expected earnings, liquidity in the market, political situation, monsoon data, pandemics, to the situation in global markets behind this undervaluation and overvaluation of the ratio.

For example, let’s look at the period of 2001 to 2013 when the markets were undervalued. Throughout this period, the earnings of NIFTY companies were increasing by 11% per annum. Still, the stock market gained annually by only 3% during these years.

This was because the stock markets had seen a massive turmoil in 2008, 2009, and 2010, where the retail investors had lost up to 50% of their wealth. Hence, they were keeping away from stocks. On the political front, this was a period of policy paralysis with clearances not happening and projects being stalled. On the global front, there was the European debt crisis.

Also, remember, stocks often compete with fixed deposits for a share of the investor’s money. In 2011, 2012, and 2013, the State Bank of India offered over 9% interest on a 1-year FD. This resulted in people preferring to put their money in assured interest instruments like fixed deposits rather than riskier asset classes like equities.

**PE Ratio and Stock Market Performance**

It is believed that the point at which you enter the market determines the returns you make. Well, this might be true most times, but there are other ways of looking at it. Let’s understand this using the NIFTY 50 data over a long period as an example.

The above graph shows the data from January 1999 to September 2020 (261 months). It can be seen that the NIFTY PE ratio has spent a considerable time outside of its mean of 20.

In fact, if we take a PE ratio slab of 18 to 22 (that’s 20 plus-minus 2), you will see that the PE ratio was within this band in only 37% of these 261 months. The NIFTY had a PE of less than 18 in 84 months, and the NIFTY PE ratio was over 22 in 81 months. So, up to 18 for 84 months, 18 to 22 for 96 months, and 22 & above for 81 months. That’s a pretty even distribution.

Next, let’s look at the implications of investing at different NIFTY PE ratios on your investment returns. For this, we assume all the investments are made in a NIFTY 50 Index fund.

As you can see, investing in months where the PE ratio is at the lower end can be hugely profitable over the next 12 months. And while investing in equities for just 1 year is not suggested, this knowledge can be tactically used by you if the markets were to fall dramatically like what happened in the months of March and April of this year.

Now, let’s look at the performance when the investment is made for a 3 or 5 year period. You will notice t the big variability in returns that we saw in the 1-year data has been significantly reduced. And although 29% to -9% is still big, it starts showing a pattern. So, if your investment horizon is short, i.e., 3 to 5 years, then you should be careful about the levels at which you are entering the market. That’s because if you enter the market when the valuations are rich,i.e., 24 or more, then the chances of you making returns greater than the inflation rate are slim if you are investing for only 3 or 5 years.

And finally, let’s understand performance numbers when investing for a longer period of time, like 7 years and more. The variability in returns goes down, and the performance numbers are much consistent and clearer. For example, look at the 15 years data. If you had invested 15 years back in a month when the PE ratio was 15, you would have made 14% annualized returns. That is understandable. But if you had invested 15 years back in a month when the PE ratio was 25, you would still have made a respectable annualized return of 12% during these 15 years.

Hence the longer your goal duration, the less variable and more predictable will be your returns.

So if you are still worried about when to enter the market so that you can start accumulating that massive corpus for your retirement or your daughter’s education, you don’t have to wait for any further and can start your investments right now irrespective of what the PE ratio is.

In other words, time removes any fears of investing in an overvalued market or dissipates the happiness of having invested in an undervalued one.

**PE Ratios and Mutual Fund Investing**

Let’s understand how you can use the concept of PE ratio while investing in mutual funds.

**Use Index Funds to invest with PE ratio tanks**

Index funds mimic the stock markets, and hence, their prices represent the stock market’s state of overvaluation or undervaluation. So if the PE ratio of an index like the NIFTY 50 goes down to, let’s say to 18, 17, 15, or thereabouts, we have enough data to suggest that the PE ratio will revert back to its mean of 20 eventually. So this becomes a great time to invest.

**Use Thematic Funds or Sectoral Funds But with Caution**

Thematic or sector funds are generally riskier than broader schemes. But not always. We say so because what we saw above, i.e., the PE ratio at which you invest, has a bearing on your portfolio risk and portfolio return. This means if you invest in such a fund when the PE ratios are low, then the chances of you making high returns on your investments increase, and the chances of you making negative returns decrease in a similar proportion.

However, there is some risk in this approach but still a technique that can be employed if it suits your risk appetite. For instance, right now, the technology stocks and the pharma sector are the darlings of the stock market. But just a year back, in 2019, these sectors were total laggards and were even giving negative returns in terms of stock performance. So if you had picked these sectors when others are not keen and waited patiently, it can turn into an excellent investment. But having said this, please do note that these sectoral funds will continue to have a far larger variability element as compared to broader funds like large or multi-cap funds, so it is advised not having more than 7-8% of your portfolio towards thematic funds.

**Invest in Balanced Advantage Funds**

Looking at PE ratios and rejigging your portfolio can be a lot of work, and most people avoid this hassle. Luckily, there is a way to automate this with Balanced Advantage Funds.

The Balanced Advantage Funds are designed to arrange the composition of equity and debt in the scheme on the basis of current market conditions and expectations in the future.

For example, ICICI Prudential Balanced Advantage Fund, which is the largest fund in the balanced advantage category, frequently changes its equity and debt allocation depending on the stock market conditions. For instance, before the stop market fall of March 2020, the NIFTY was very expensive at over 12,000 levels. This is when the ICICI Prudential Balanced Advantage Fund took a conservative stand and kept the equity proportion of their fund at less than 50%.

But when the stock markets tanked in March and equities became attractive, the fund’s investment team jumped in and reallocated money from debt back to equities to take the composition up to 70%.

This automatic play by Balanced Advantage Funds is mostly based on the PE ratio model and helps investors manage stock market variability better and get above-average returns at below-average risk.

**Bottom Line:**

There is no denying that the understanding of the PE ratio is important and has a strong bearing on returns and risk over the short run. And our studies also show that long-term investing is a great way to reduce variability in investment returns and manage risk better.

However, don’t let the PE ratio not deter you from your long-term goals, but at the same time, don’t be blind to it.

And the best way to ensure you are continuously improving your portfolio’s risk-adjusted returns is by following a disciplined investing strategy with

- Investing via SIPs or systematic investment plans
- Deciding the asset allocation that you are most comfortable with
- Rebalancing your portfolio every 12 months