Before I decide whether to buy a bank’s shares, I always like to look at its return on equity and its core tier 1 capital ratio.
These core financial ratios provide an indication of how successful a bank is at generating profits using shareholders’ funds, and of how strong its finances are. As a result, both ratios can have a strong influence on dividend payments and share price growth.
Today, I’m going to take a look at Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US), to see how attractive it looks on these two measures.
Return on equity
The return a company generates on its shareholders’ funds is known as return on equity, or ROE. Return on equity can be calculated by dividing a company’s annual profit by its equity (ie, the difference between its total assets and its total liabilities) and is expressed as a percentage.
Lloyds’ share price is now up by 66% on the low reached in March 2009, but its share price gains have not been reflected in its return on equity, as these figures show:
| Lloyds Banking Group | 2008 | 2009 | 2010 | 2011 | 2012 | Average |
|---|---|---|---|---|---|---|
| ROE | 7.2% | 10.7% | -0.8% | -6.1% | -3.2% | 1.6% |
Like several other UK banks, Lloyds has spent most of the last three years clearing the skeletons from its cupboards.
Last year was a particular low point, thanks to £3.6bn of provisions made against potential Payment Protection Insurance (PPI) mis-selling claims.
Is it time to buy Lloyds?
One way of assessing a bank’s risk is with its core tier 1 capital ratio, which compares the value of the bank’s retained profits and equity with its loan book.
In the table below, I’ve listed Lloyds’ core tier 1 capital ratio, ROE and price to book value, alongside those of its UK-focused peers, Barclays and Royal Bank of Scotland Group.
| Company | Price to tangible book value |
Core Tier 1 Capital Ratio |
5-year average ROE |
|---|---|---|---|
| Royal Bank of Scotland | 72% | 10.8% | -7.8% |
| Lloyds | 125% | 12.5% | 1.6% |
| Barclays | 92% | 11.0% | 6% |
Although Lloyds’ core tier 1 capital ratio is the strongest of the three UK-focused big banks, I’m concerned that Lloyds’ valuation, which is 25% above its tangible book value, has got ahead of itself.
Sell Lloyds?
Legendary City fund manager Neil Woodford recently said that he believes that the “process of loss recognition still has several years to run” for UK-focused high street banks like Lloyds.
Despite this, Lloyds shares currently trade on a forward P/E of 15, higher than dividend-paying Barclays or HSBC. Frankly, I can’t see much upside in Lloyds share price, and would rate the bank as a sell.
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> Roland owns shares in HSBC Holdings but does not own shares in any of the other companies mentioned in this article.
