Can First American Financial Corporation's (NYSE:FAF) Weak Financials Pull The Plug On The Stock's Current Momentum On Its Share Price?

Most readers would already be aware that First American Financial's (NYSE:FAF) stock increased significantly by 7.2% over the past week. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. Specifically, we decided to study First American Financial's ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.

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How To Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for First American Financial is:

3.7% = US$191m ÷ US$5.1b (Based on the trailing twelve months to June 2025).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.04 in profit.

View our latest analysis for First American Financial

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

First American Financial's Earnings Growth And 3.7% ROE

It is hard to argue that First American Financial's ROE is much good in and of itself. Even compared to the average industry ROE of 13%, the company's ROE is quite dismal. For this reason, First American Financial's five year net income decline of 37% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.

So, as a next step, we compared First American Financial's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 14% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about First American Financial's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is First American Financial Using Its Retained Earnings Effectively?

With a three-year median payout ratio as high as 101%,First American Financial's shrinking earnings don't come as a surprise as the company is paying a dividend which is beyond its means. Paying a dividend higher than reported profits is not a sustainable move.

Moreover, First American Financial has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 34% over the next three years. The fact that the company's ROE is expected to rise to 11% over the same period is explained by the drop in the payout ratio.

Summary

In total, we would have a hard think before deciding on any investment action concerning First American Financial. The low ROE, combined with the fact that the company is paying out almost if not all, of its profits as dividends, has resulted in the lack or absence of growth in its earnings. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.