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Do You Know What Sound Financial Bancorp, Inc.'s (NASDAQ:SFBC) P/E Ratio Means?

Simply Wall St

To the annoyance of some shareholders, Sound Financial Bancorp (NASDAQ:SFBC) shares are down a considerable in the last month. The recent drop has obliterated the annual return, with the share price now down 13% over that longer period.

Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). 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 ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.

See our latest analysis for Sound Financial Bancorp

How Does Sound Financial Bancorp's P/E Ratio Compare To Its Peers?

Sound Financial Bancorp's P/E of 11.53 indicates some degree of optimism towards the stock. You can see in the image below that the average P/E (9.9) for companies in the banks industry is lower than Sound Financial Bancorp's P/E.

NasdaqCM:SFBC Price Estimation Relative to Market, March 16th 2020

Its relatively high P/E ratio indicates that Sound Financial Bancorp shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Sound Financial Bancorp's earnings per share fell by 6.2% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 9.4%.

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

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

How Does Sound Financial Bancorp's Debt Impact Its P/E Ratio?

With net cash of US$36m, Sound Financial Bancorp has a very strong balance sheet, which may be important for its business. Having said that, at 45% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Bottom Line On Sound Financial Bancorp's P/E Ratio

Sound Financial Bancorp has a P/E of 11.5. That's below the average in the US market, which is 14.0. Falling earnings per share are likely to be keeping potential buyers away, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there's real potential that the low P/E could eventually indicate undervaluation. Given Sound Financial Bancorp's P/E ratio has declined from 11.5 to 11.5 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.

When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

But note: Sound Financial Bancorp 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.

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.