Jargon buster: Technical terms every mutual fund investor must know

We keep harping on investing in Mutual Funds regularly and systematically.  But we often forget, Mutual Funds are nothing but a compilation of various companies mostly listed in the stock market. Therefore as Mutual Fund investors, we should evaluate the portfolio closely to understand the probability of the fund generating long term returns. This is only possible if you can deconstruct some of the financial jargon that you regularly encounter.

Next time you look at your Mutual Fund portfolio, think about these:

Market Capitalisation or Market Cap

The Market Cap of the company is nothing but the total market value of the company. If you multiply the value of one share by the total number of shares in issue, you would obtain the Market Capitalisation. Thinking about it in another way, it is the amount that one has to pay to completely to buy the company. For instance, as of today the Market Cap of TCS is 4,91,000 Crores! You could compare this to the Market Cap of Infosys, which is about 2,63,000 crores. In essence in terms of total value, Infosys is cheaper than TCS.

Earnings Per Share or EPS

Earnings Per share is the Net Profit of the company divided by the total number shares. It is often referred to as EPS. Higher the EPS, the better. Quite obvious! More profits per share. Infosys’s EPS is about 55, while TCS’s is 105! TCS makes more money per share compared to Infosys. No wonder it is at a higher Market Cap, isn’t it?

Price to Earnings Ratio or P/E ratio

A very important metric to value a company is the P/E ratio. It is defined as Price per share divided by the Earnings per share. For instance the Price of Infosys in the stock market today is about 1142 and the earnings per share is 55. The P/E ratio of Infosys  is 1142/55 equating to approximately 21. Compare this to TCS, which if you calculate comes out to be 23. What this means is that for the same earnings, TCS is valued at a higher rate than Infosys. The stock market feels that TCS will grow better in the future than Infosys, which may or may not be the case.

Therefore the P/E ratio is a simple metric to compare the valuation of several companies in the same segment. There could be bargains in the market, i.e companies with lower P/E ratios than peers. Hold on, there is a caveat. The reason for the smaller P/E ratio could be due to the fact that the company may  not be growing, or even worse, not reputed in the field they work in. So one needs to be very careful.

As a start, calculate the P/E ratios of all the companies in the Mutual Fund you own.

Dividends

You must have heard of this term before. Dividends are nothing but a sum of money paid by the company to the shareholders, ideally a part of the profit the company has made. Let’s say a company makes 100 crore profit for the year. The company may decide to share 20 crores of the 100 crores with shareholders as cash and reinvest the rest into the business to grow. This is considered very healthy as it ensures that the profits reported by the company are real. Next time you look at your Mutual Fund portfolio, check each company’s dividend pay-out percentages.

Equity

Again, you must have heard this term before. Equity in simple terms is the difference between the company’s assets and liabilities. For example if you buy a house for 1 crore and take a loan of 20 lakhs. Then simply your individual equity is 80 lakhs, the money you put in. Equity can be negative if there are more liabilities than assets.

Debt to Equity ratio

It is the ratio between the total debt to the total equity (defined previously). Higher the ratio, greater the risk! Ideally should be less than 0.5, but some companies especially banks have a lot more debt. Companies borrow to grow, but sometimes if the growth doesn’t happen then it can get into trouble and end up being bankrupt! We love Debt Free Companies!

Book Value

The book is the net asset value of the company minus any liabilities. It is what you probably get if you liquidate everything in the company and pay of all liabilities including any taxes. You would be surprised that some companies are valued below their book value in the stock market.  That would mean that the market is extremely pessimistic about the business’s future.  These kinds of situations may be an opportune moment to pick up value buys. Next time, just look up the ratio called Price to Book or P/B. If it is less than 1, that means the entire enterprise value is less than the cash value of the company. Its like paying say 10 INR for a 50 INR note.

It is our responsibility to be aware of the investments we make. Therefore the next time you invest in a Mutual Fund, try analysing the portfoilio using these simple ratios and terms. It may come of use to finally select a fund that pays! Most importantly, you know where your money is invested.

Arjun Balakrishnan is an investment fanatic who loves writing about investment topics. He regularly writes at Investment Gyaan.

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