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A Sliding Share Price Has Us Looking At First American Financial Corporation's (NYSE:FAF) P/E Ratio

To the annoyance of some shareholders, First American Financial (NYSE:FAF) shares are down a considerable 31% in the last month. The recent drop has obliterated the annual return, with the share price now down 20% over that longer period.

Assuming nothing else has changed, a lower share price makes a stock more attractive to potential buyers. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. The implication here is that long term investors have an opportunity when expectations of a company are too low. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.

See our latest analysis for First American Financial

Does First American Financial Have A Relatively High Or Low P/E For Its Industry?

First American Financial's P/E of 6.78 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (9.2) for companies in the insurance industry is higher than First American Financial's P/E.

NYSE:FAF Price Estimation Relative to Market April 1st 2020
NYSE:FAF Price Estimation Relative to Market April 1st 2020

First American Financial's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Notably, First American Financial grew EPS by a whopping 48% in the last year. And its annual EPS growth rate over 5 years is 23%. So we'd generally expect it to have a relatively high P/E ratio.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

First American Financial's Balance Sheet

With net cash of US$529m, First American Financial has a very strong balance sheet, which may be important for its business. Having said that, at 11% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Bottom Line On First American Financial's P/E Ratio

First American Financial has a P/E of 6.8. That's below the average in the US market, which is 13.1. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. The relatively low P/E ratio implies the market is pessimistic. What can be absolutely certain is that the market has become more pessimistic about First American Financial over the last month, with the P/E ratio falling from 9.8 back then to 6.8 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for deep value investors this stock might justify some research.

When the market is wrong about a stock, it gives savvy investors an opportunity. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than First American Financial. So you may wish to see this free collection of other companies that have grown earnings strongly.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.