Here is a quick and dirty way to check if a mutual fund is doing good, or will do good for you, before buying it. I use it before I buy a mutual fund. All you need is a list of companies, which stocks are currently held in the fund’s portfolio.

You may or may not have heard about Price/Earnings ratio (P/E ratio). It’s a simple math formula that simply calculated by a division between a current share/stock price and the company earnings per share. Let say a market Google’s share price is $500, and Google earns $20 per share, thus P/E ratio will be $500/$20=25. So, what does it mean? It simply means that the Google’s stock is overpriced, and probably will not give you a good profit over time.

If a company’s stock has a $20 price tag and it’s P/E is 3, then it means that there is a big opportunity that the share price will grow, and will make you a significant profit. the lower P/E, the better your chance for the profit are, and it also means that the stock is underpriced.

However, this approach is very simplistic, because there are other factors that can affect P/E ratio or ability to make profit: company funding, company debt, innovations and etc. There are also different treatments of this ratio, and some of the investors say that “high P/E suggests that investors are expecting higher earnings growth in the future”. In my system, overpriced company is an overpriced company, and betting on its future possible growth requires a very detailed research of who is the CEO, what are their plans and do they have an office drama. Do we have time for that?

Anyway, it’s a good instrument to check company’s health in most cases. As you know, a mutual fund buys and sells stocks of different companies, so we can see the “future” by checking the list of those companies.

If you find out that the majority of the purchased stocks on the mutual fund’s list have P/E of 20 and up - that should be a red flag for you. You also need to check what is the average P/E in each industry to compare the companies, for instance, IT industry may have average of 20, and Health Care may have 15 - use those values to make your decision, and look for companies below those levels.

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