When close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 17x, you may consider First American Financial Corporation (NYSE:FAF) as a stock to avoid entirely with its 34.5x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

First American Financial has been struggling lately as its earnings have declined faster than most other companies. It might be that many expect the dismal earnings performance to recover substantially, which has kept the P/E from collapsing. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Is There Enough Growth For First American Financial?

The only time you'd be truly comfortable seeing a P/E as steep as First American Financial's is when the company's growth is on track to outshine the market decidedly.

Retrospectively, the last year delivered a frustrating 19% decrease to the company's bottom line. This means it has also seen a slide in earnings over the longer-term as EPS is down 79% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Turning to the outlook, the next three years should generate growth of 43% per annum as estimated by the four analysts watching the company. Meanwhile, the rest of the market is forecast to only expand by 10% per year, which is noticeably less attractive.

In light of this, it's understandable that First American Financial's P/E sits above the majority of other companies. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Key Takeaway

Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

As we suspected, our examination of First American Financial's analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. Unless these conditions change, they will continue to provide strong support to the share price.

You always need to take note of risks, for example - First American Financial has 1 warning sign we think you should be aware of.

If these risks are making you reconsider your opinion on First American Financial, explore our interactive list of high quality stocks to get an idea of what else is out there.

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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.