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Read This Before You Buy Central Federal Corporation (NASDAQ:CFBK) Because Of Its P/E Ratio

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To the annoyance of some shareholders, Central Federal (NASDAQ:CFBK) shares are down a considerable in the last month. Even longer term holders have taken a real hit with the stock declining 8.6% in the last year.

All else being equal, a sharp share price increase should make a stock less attractive to potential investors. 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. Perhaps the simplest way to get a read on investors' expectations of a business 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 Central Federal

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

We can tell from its P/E ratio of 5.44 that sentiment around Central Federal isn't particularly high. If you look at the image below, you can see Central Federal has a lower P/E than the average (12.2) in the mortgage industry classification.

NasdaqCM:CFBK Price Estimation Relative to Market, March 11th 2020
NasdaqCM:CFBK Price Estimation Relative to Market, March 11th 2020

Central Federal's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Central Federal, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Central Federal's 111% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The sweetener is that the annual five year growth rate of 154% is also impressive. So I'd be surprised if the P/E ratio was not above average.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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.

How Does Central Federal's Debt Impact Its P/E Ratio?

Since Central Federal holds net cash of US$2.2m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Bottom Line On Central Federal's P/E Ratio

Central Federal has a P/E of 5.4. That's below the average in the US market, which is 15.3. Not only should the net cash position reduce risk, but the recent growth has been impressive. The relatively low P/E ratio implies the market is pessimistic. Given Central Federal's P/E ratio has declined from 5.4 to 5.4 in the last month, we know for sure that the market is more worried 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 deep value investors this stock might justify some research.

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. Although we don't have analyst forecasts you might want to assess this data-rich visualization of earnings, revenue and cash flow.

But note: Central Federal 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.