Do You Like First American Financial Corporation (NYSE:FAF) At This P/E Ratio?
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
First American Financial Corporation (NYSE:FAF) trades with a trailing P/E of 10.2x, which is lower than the industry average of 16.5x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
View our latest analysis for First American Financial
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for FAF
Price-Earnings Ratio = Price per share ÷ Earnings per share
FAF Price-Earnings Ratio = $43.18 ÷ $4.224 = 10.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to FAF, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. FAF’s P/E of 10.2 is lower than its industry peers (16.5), which implies that each dollar of FAF’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Insurance companies in US including Genworth Financial, Syncora Holdings and Reinsurance Group of America. You can think of it like this: the market is suggesting that FAF is a weaker business than the average comparable company.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to FAF, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with FAF, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing FAF to are fairly valued by the market. If this does not hold true, FAF’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to FAF. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
Future Outlook: What are well-informed industry analysts predicting for FAF’s future growth? Take a look at our free research report of analyst consensus for FAF’s outlook.
Past Track Record: Has FAF been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of FAF’s historicals for more clarity.
Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.
