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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Guaranty Federal Bancshares, Inc.'s (NASDAQ:GFED) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Guaranty Federal Bancshares has a P/E ratio of 12.59. In other words, at today's prices, investors are paying $12.59 for every $1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Guaranty Federal Bancshares:
P/E of 12.59 = $23.05 ÷ $1.83 (Based on the year to March 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
In the last year, Guaranty Federal Bancshares grew EPS like Taylor Swift grew her fan base back in 2010; the 58% gain was both fast and well deserved. Having said that, if we look back three years, EPS growth has averaged a comparatively less impressive 12%.
How Does Guaranty Federal Bancshares's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Guaranty Federal Bancshares has a lower P/E than the average (14.2) in the mortgage industry classification.
Its relatively low P/E ratio indicates that Guaranty Federal Bancshares shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.
Guaranty Federal Bancshares's Balance Sheet
Guaranty Federal Bancshares's net debt equates to 34% of its market capitalization. While it's worth keeping this in mind, it isn't a worry.
The Verdict On Guaranty Federal Bancshares's P/E Ratio
Guaranty Federal Bancshares's P/E is 12.6 which is below average (17.7) in the US market. The company hasn't stretched its balance sheet, and earnings growth was good last year. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue. Since analysts are predicting growth will continue, one might expect to see a higher P/E so it may be worth looking closer.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
You might be able to find a better buy than Guaranty Federal Bancshares. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.