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It is hard to get excited after looking at First American Financial's (NYSE:FAF) recent performance, when its stock has declined 20% over the past three months. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. In this article, we decided to focus on First American Financial's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.
How Is ROE Calculated?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for First American Financial is:
21% = US$1.1b ÷ US$5.4b (Based on the trailing twelve months to March 2022).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.21 in profit.
What Has ROE Got To Do With Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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 21% ROE
At first glance, First American Financial seems to have a decent ROE. On comparing with the average industry ROE of 12% the company's ROE looks pretty remarkable. This certainly adds some context to First American Financial's exceptional 25% net income growth seen over the past five years. However, there could also be other causes behind this growth. For instance, the company has a low payout ratio or is being managed efficiently.
Next, on comparing with the industry net income growth, we found that First American Financial's growth is quite high when compared to the industry average growth of 14% in the same period, which is great to see.
Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if First American Financial is trading on a high P/E or a low P/E, relative to its industry.
Is First American Financial Making Efficient Use Of Its Profits?
First American Financial's three-year median payout ratio is a pretty moderate 29%, meaning the company retains 71% of its income. So it seems that First American Financial is reinvesting efficiently in a way that it sees impressive growth in its earnings (discussed above) and pays a dividend that's well covered.
Additionally, First American Financial has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 30% of its profits over the next three years. However, First American Financial's future ROE is expected to decline to 11% despite there being not much change anticipated in the company's payout ratio.
Overall, we are quite pleased with First American Financial's performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. Having said that, on studying current analyst estimates, we were concerned to see that while the company has grown its earnings in the past, analysts expect its earnings to shrink 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.