With its stock down 6.5% over the past three months, it is easy to disregard First American Financial (NYSE:FAF). To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. In this article, we decided to focus on First American Financial's ROE.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for First American Financial

How Do You Calculate Return On Equity?

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:

2.7% = US$133m ÷ US$4.9b (Based on the trailing twelve months to December 2024).

The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.03 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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 2.7% ROE

It is quite clear that First American Financial's ROE is rather low. Even when compared to the industry average of 14%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 29% seen by First American Financial was possibly a result of it having a lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

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. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. Is First American Financial fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is First American Financial Efficiently Re-investing Its Profits?

First American Financial has a high three-year median payout ratio of 92% (that is, it is retaining 7.9% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 3 risks we have identified for First American Financial by visiting our risks dashboard for free on our platform here.

In addition, First American Financial has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 31% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 13%, over the same period.

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.