With the recent sell-off in global stock markets, quite a few UK banks seem to be selling at very attractive valuations. Barclays (LSE: BARC) and Lloyds Banking Group (LSE: LLOY), in particular, seem to be presenting attractive entry points for new positions. Their low valuation multiples, strong balance sheets and robust earnings outlook may indicate their shares have now been oversold.

Diversification vs Focus

Although both bank stocks are very appealing, there are major differences between the two banks. Barclays is very much a diversified bank, with sizeable businesses in UK retail and commercial banking, investment banking, credit cards and banking in Africa. Lloyds, on the other hand, has adopted a simple UK business model, focusing primarily on retail and commercial banking.

There are advantages and disadvantages with both strategies. Focusing on a small number of markets allows banks to concentrate their financial and human resources, which enables them to make cost savings and build scale. This helps explain why Lloyds has such a low cost efficiency ratio: 51% vs 65% at Barclays’ core business.

Meanwhile, diversification allows banks to spread risks across multiple markets and between different countries. This can help banks to reduce earnings volatility and allow it to take advantage of faster growing, or more profitable, markets. Here, Barclays benefits from huge growth potential from its Africa business, where it operates in one of the least penetrated banking systems in the world, and industry-leading profitability from Barclaycard. But, on the other hand, Barclays’ investment bank and legacy European retail business continues to under perform the rest of the group.

High P/B, High ROE or Low P/B, Low ROE

The return on equity (ROE) is one of the most important financial metrics for comparing between banks, as it is a simple measure of the amount of profit generated from each pound in equity put forward by shareholders. Thus, banks that have higher ROEs are considered to be more profitable.

  P/B Underlying ROE (2014) P/E (Underlying 2014 EPS) P/E (2015 Forecast)
Barclays  0.53   5.1%  11.7  10.6
Lloyds Banking Group   1.00   13.6%   8.4  8.6 

Here, we find that Lloyds has a significantly higher price-to-book (P/B) ratio than Barclays, but also a much higher return on equity. The greater profitability of Lloyds means it can generate more profit for every £1 in equity the bank holds. So, although Lloyds has a much higher price-to-book (P/B) ratio than Barclays, Lloyds still ends up having a lower price-to-earnings ratio (P/E) than Barclays.

Which stock would I buy?

My pick would be Lloyds. The bank is much further ahead with its recovery since the Great Recession of 2007-9, as evidenced by its stronger underlying financial performance and smaller portfolio of under-performing loans and assets. Its relatively low forward P/E ratio and a potential return to more substantial dividend payments this year further adds to why Lloyds seems to be the better buy.

However, it is hard to ignore the fact that Barclays is substantially cheaper on a P/B basis. This could indicate that Barclays has greater potential from turning around under-performing parts of the business, as although Barclays has underperformed Lloyds in the past, the gap between the returns in equity of these two banks should begin to narrow.  

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.