Bowl America Incorporated (AMEX:BWL.A) is trading with a trailing P/E of 30.1x, which is higher than the industry average of 25.6x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for BWL.A
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for BWL.A
Price-Earnings Ratio = Price per share ÷ Earnings per share
BWL.A Price-Earnings Ratio = 14.3 ÷ 0.475 = 30.1x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to BWL.A, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. BWL.A’s P/E of 30.1x is higher than its industry peers (25.6x), which implies that each dollar of BWL.A’s earnings is being overvalued by investors. As such, our analysis shows that BWL.A represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your BWL.A shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to BWL.A, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with BWL.A, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing BWL.A to are fairly valued by the market. If this does not hold true, BWL.A’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on BWL.A, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.