Is First American Financial Corporation's (NYSE:FAF) Stock On A Downtrend As A Result Of Its Poor Financials?

First American Financial (NYSE:FAF) has had a rough month with its share price down 11%. To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. Particularly, we will be paying attention to First American Financial's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for First American Financial

How Do You Calculate Return On Equity?

The formula for return on equity is:

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

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

1.8% = US$94m ÷ US$5.1b (Based on the trailing twelve months to September 2024).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.02 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

First American Financial's Earnings Growth And 1.8% 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 14%, the company's ROE is quite dismal. Therefore, it might not be wrong to say that the five year net income decline of 24% seen by First American Financial was possibly a result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. Such as - low earnings retention or poor allocation of capital.

However, when we compared First American Financial's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 13% in the same period. This is quite worrisome.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is First American Financial fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is First American Financial Using Its Retained Earnings Effectively?

First American Financial's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 90% (or a retention ratio of 9.6%). With only very little left to reinvest into the business, growth in earnings is far from likely. To know the 2 risks we have identified for First American Financial visit our risks dashboard for free.

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 31% over the next three years. The fact that the company's ROE is expected to rise to 12% over the same period is explained by the drop in the payout ratio.

Conclusion

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. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.