Shares in Lloyds Banking Group (LSE: LLOY) have enjoyed a strong run since its February earnings announcement, but they’re still worth holding due to strong underlying earnings growth and continued out-performance relative to rivals.

Strong underlying profitability

In contrast to the other big four UK banks, shares in Lloyds are worth more than its tangible net asset value, with it trading at a price-to-tangible book value (P/TBV) of 1.29. At first glance, Lloyds appears expensive, but its high valuation multiple is justified when we take account the bank’s strong near-term outlook.

Lloyds’ market capitalisation could be worth £16bn more as return on equity converges with its medium-term target of 13.5% to 15%. Currently, its statutory return on equity is well short of its medium-term target, at 1.5%. But its underlying return on equity, which strips out costs for restructuring, asset sales and legacy misconduct costs from operating expenses, is already at 15%.

The strong underlying performance is the result of its simple business model: focusing almost entirely on UK retail and commercial banking and leveraging its local scale and efficiency to strengthen its competitive advantage. Lloyds has made steady progress with lowering operating costs and already has the lowest cost structure of the big four.

With a cost-to-income figure of 49.3%, the bank is close to its medium-term target of 45%. This compares favourably to its rivals and explains why Lloyds is making a faster recovery.

Worth 1.7x P/TBV?

Continued progress in improving credit quality, capital and profitability metrics should mean its shares could easily justify a P/TBV of 1.7 times, for a value of 91.5p per share. That would give a potential upside of 33%, equivalent to a £16bn increase in market capitalisation.

Although this seems like a pricey valuation premium, solid earnings growth should mean Lloyds would still be attractive earnings-wise. Even at 91.5p per share, the bank would carry a 2016 forward P/E of just 12.3. Moreover, its estimated forward P/E would fall to just 11.5 by 2017, showing how continued earnings growth and strong underlying profitability metrics justify a high P/TBV ratio.

Additionally, robust dividend growth supports the valuation. With shares valued at 91.5p each, its 2017 prospective yield would be more than 5.5%, with the estimated 2016 dividend yield at 4.5%. And shares in Lloyds have yet to go ex-dividend for its 2015 final and special dividends, which means investors who buy shares before 7 April (and continue to hold them until that date) will be entitled to a combined 2.0p payment in May.

Downside risks

Investing in Lloyds isn’t without its risks. While it benefits from a solid deposit base, it’s somewhat more reliant on short-term wholesale funding than some rivals. Its loan to deposit ratio is consistently above 100% (currently 109%), so much of the gap in funding is plugged by the more volatile wholesale markets. This puts Lloyds at risk of liquidity problems if investor confidence collapses, as during the 2007/8 financial crisis.

With limited diversification, the bank is almost entirely exposed to the UK economy and respected fund manager Neil Woodford is particularly concerned about its exposure to the UK property market. Mortgages account for around 70% of all customer loans for Lloyds, meaning it would be highly vulnerable to a potential downturn. On the upside, most mortgages have a loan-to-value (LTV) of less than 60% and property prices are expected to climb, due to chronically weak supply growth.

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