P/E Ratio Trading Strategy: How to Find Undervalued Stocks & Trade Options in India

The Price-to-Earnings (P/E) ratio is a core fundamental valuation metric. It represents the ratio between a company's current market price per share and its earnings per share (EPS) over the trailing twelve months (TTM). The formula is simple: P/E Ratio = Current Share Price / Earnings Per Share (EPS).

For example, if a company's stock trades at ₹200 and its TTM EPS is ₹20, its P/E ratio is 10. This means investors are willing to pay ₹10 for every ₹1 of earnings the company generates. A higher P/E often suggests investors anticipate higher future earnings growth, while a lower P/E might indicate the stock is undervalued or has lower growth expectations.

The P/E ratio provides crucial insights into market sentiment and a company's valuation relative to its industry peers and its own historical performance. Traders and investors use P/E ratios to spot potential mispricings. A common approach is to look for companies trading at a P/E significantly below their industry average or historical norms. The hypothesis is that these stocks are undervalued and may experience price appreciation as the market recognizes their true worth. This forms the foundation of a P/E ratio trading strategy, particularly when applied to equities and their derivatives.

A P/E ratio trading strategy leverages P/E multiples as a key signal for trade entry and exit, often in conjunction with other technical or fundamental indicators. The core principle is to profit from discrepancies between a stock's current P/E and its perceived intrinsic value based on earnings power.

This strategy is particularly effective when applied to equity derivatives like stock options. A trader might use P/E analysis to identify fundamentally sound stocks that appear undervalued, then utilize options to magnify potential returns from price movements or to implement income-generating strategies. For example, a trader might buy call options on a stock deemed undervalued by its P/E, expecting its price to rise.

To construct a robust P/E ratio trading strategy, define precise rules for stock selection, trade entry, exit, and rigorous risk management.

For instance, consider Company X. Its current P/E is 14. Its 5-year average P/E is 22. Its closest competitor, Company Y, trades at a P/E of 18. Company X's EPS trajectory was ₹8 in FY21, ₹9 in FY22, and ₹10.5 in FY23.

Entry Rule: After a stock meets your P/E selection criteria, wait for a confirmation from technical analysis. This could be a breakout above a significant resistance level, a bullish crossover of moving averages (like the 50-day MA crossing above the 200-day MA), or a recognized bullish candlestick pattern on the daily chart. For example, initiate a long call option position if the stock breaks above its 50-day Exponential Moving Average (EMA) after meeting the P/E criteria.

Exit Rule (Profit Taking): Define a profit target based on the P/E ratio. Exit the position when the stock's P/E reaches its 5-year average or a predetermined target P/E (e.g., P/E of 20 for Company X). Alternatively, set a price target, such as a 25% increase from the entry price.

Exit Rule (Stop Loss): Implement a stringent stop-loss mechanism. Exit the position if the stock price declines by 10-15% from the entry price. For option trades, a stop loss on the option premium could be set at 50% of the initial premium paid.

Let's illustrate with a hypothetical scenario using a large-cap Indian company, HDFC Bank, with simplified figures.

In this example, HDFC Bank's current P/E of 20 is below its historical average of 26. When it broke its 50-day EMA, a long call option was purchased with a strike price of ₹1520, costing ₹10 per share (₹250 per lot for Nifty options, which have 25 shares). The target was to exit when HDFC Bank's P/E reached 26, implying a target price of ₹1950. If this target was achieved, the call option's value would significantly increase, leading to a profitable trade. The P&L shown (+Rs 7,500) is for one lot of Nifty options, illustrating the profit potential based on the underlying's price movement driven by P/E expansion.

For executing and managing such trades efficiently, a platform like OptionX offers tools such as a Strategy Builder to construct complex option positions and OCO (One-Cancels-the-Other) orders to automatically manage profit targets and stop losses simultaneously, streamlining the execution process.

While the P/E ratio strategy can be a valuable tool, it's crucial to acknowledge its inherent risks. P/E ratios are primarily backward-looking metrics and don't always accurately predict future earnings or stock performance.

Industry Nuances: P/E norms differ vastly across industries. A P/E of 20 might be considered low for a high-growth technology company but excessively high for a mature utility or banking stock. Always compare P/E ratios within the same industry sector.

Accounting Changes & One-Off Events: Corporate earnings can be influenced by changes in accounting standards, significant one-time gains (like asset sales) or losses, or debt restructuring. These events can artificially inflate or deflate EPS, thereby distorting the P/E ratio and making it a less reliable indicator.

Option Strategy Risks: Trading options involves specific risks. Buying options (like calls or puts) offers limited risk (premium paid) but requires the underlying asset to move significantly in the desired direction within the option's expiry to be profitable. Selling options, while potentially generating income, carries substantial risk, including potentially unlimited losses for uncovered short calls, if not managed with strict risk controls like defined-risk spreads or adequate hedging.