Read This Before You Buy Bowl America Incorporated (NYSEMKT:BWL.A) Because Of Its P/E Ratio

Unfortunately for some shareholders, the Bowl America (NYSEMKT:BWL.A) share price has dived in the last thirty days. Indeed, the recent drop has reduced the annual gain to a relatively sedate 3.7% over the last twelve months.

Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. So some would prefer to hold off buying when there is a lot of optimism towards a stock. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.

Check out our latest analysis for Bowl America

How Does Bowl America's P/E Ratio Compare To Its Peers?

We can tell from its P/E ratio of 27.82 that there is some investor optimism about Bowl America. You can see in the image below that the average P/E (24.3) for companies in the hospitality industry is lower than Bowl America's P/E.

That means that the market expects Bowl America will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Bowl America's earnings per share fell by 28% in the last twelve months. But it has grown its earnings per share by 16% per year over the last five years.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

So What Does Bowl America's Balance Sheet Tell Us?

Since Bowl America holds net cash of US$7.7m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On Bowl America's P/E Ratio

Bowl America has a P/E of 27.8. That's higher than the average in its market, which is 18.9. Falling earnings per share is probably keeping traditional value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will! Given Bowl America's P/E ratio has declined from 27.8 to 27.8 in the last month, we know for sure that the market is less confident about the business today, than it was back then. For those who don't like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. Although we don't have analyst forecasts you might want to assess this data-rich visualization of earnings, revenue and cash flow.

But note: Bowl America may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

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