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Here's How P/E Ratios Can Help Us Understand Guaranty Federal Bancshares, Inc. (NASDAQ:GFED)

Simply Wall St

To the annoyance of some shareholders, Guaranty Federal Bancshares (NASDAQ:GFED) shares are down a considerable in the last month. The bad news is that the recent drop obliterated the last year's worth of gains; the stock is flat over twelve months.

All else being equal, a sharp share price increase should make a stock less attractive to potential investors. 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. The implication here is that deep value investors might steer clear when expectations of a company are too high. 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 Guaranty Federal Bancshares

Does Guaranty Federal Bancshares Have A Relatively High Or Low P/E For Its Industry?

Guaranty Federal Bancshares's P/E of 10.86 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (12.5) for companies in the mortgage industry is higher than Guaranty Federal Bancshares's P/E.

NasdaqGM:GFED Price Estimation Relative to Market, March 8th 2020

This suggests that market participants think Guaranty Federal Bancshares will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

It's nice to see that Guaranty Federal Bancshares grew EPS by a stonking 29% in the last year. And its annual EPS growth rate over 5 years is 9.6%. I'd therefore be a little surprised if its P/E ratio was not relatively high.

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. 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).

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

Guaranty Federal Bancshares's Balance Sheet

Guaranty Federal Bancshares has net cash of US$1.0m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Verdict On Guaranty Federal Bancshares's P/E Ratio

Guaranty Federal Bancshares's P/E is 10.9 which is below average (16.2) in the US market. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. One might conclude that the market is a bit pessimistic, given the low P/E ratio. Given Guaranty Federal Bancshares's P/E ratio has declined from 10.9 to 10.9 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 prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.

Investors should be looking to buy stocks that the market is wrong about. 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.

Of course you might be able to find a better stock than Guaranty Federal Bancshares. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.

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. Thank you for reading.