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Read This Before You Buy Guaranty Federal Bancshares, Inc. (NASDAQ:GFED) Because Of Its P/E Ratio

Simply Wall St

To the annoyance of some shareholders, Guaranty Federal Bancshares (NASDAQ:GFED) shares are down a considerable in the last month. Looking back further, the stock is up 3.4% 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). So some would prefer to hold off buying when there is a lot of optimism towards a stock. 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.

View our latest analysis for Guaranty Federal Bancshares

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

We can tell from its P/E ratio of 11.27 that sentiment around Guaranty Federal Bancshares isn't particularly high. If you look at the image below, you can see Guaranty Federal Bancshares has a lower P/E than the average (13.7) in the mortgage industry classification.

NasdaqGM:GFED Price Estimation Relative to Market, February 21st 2020

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. 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

Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

It's nice to see that Guaranty Federal Bancshares grew EPS by a stonking 29% in the last year. And earnings per share have improved by 9.6% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.

Remember: P/E Ratios Don't Consider The Balance Sheet

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. 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 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.

Guaranty Federal Bancshares's Balance Sheet

The extra options and safety that comes with Guaranty Federal Bancshares's US$1.0m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

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

Guaranty Federal Bancshares's P/E is 11.3 which is below average (18.5) in the US market. 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 Guaranty Federal Bancshares's P/E ratio has declined from 11.3 to 11.3 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 have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: Guaranty Federal Bancshares 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.