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Is Lloyds Banking Group plc dead and buried after it reports sliding profitability?

Image: www.moneybright.co.uk Licence: creativecommons.org/licenses/by/2.0/

This week’s results from Lloyds (LSE: LLOY) showed that the part-nationalised bank’s profitability has declined. It fell by 15% on a pre-tax basis, while Lloyds also set aside a further £1bn for PPI claims. This shows that Lloyds isn’t yet back to full financial health. Should you therefore avoid it?

The outlook for Lloyds is highly uncertain. Brexit is likely to significantly affect its share price performance simply because Lloyds has major exposure to the UK economy. Lower interest rates may help to ease default rates and cause demand for new loans to remain high. However, the reality is that the Bank of England expects unemployment to rise and this could cause slower growth in demand for new credit over the medium term. Similarly, low GDP growth may also hurt Lloyds’ future prospects.

However, Lloyds is well-placed to overcome the challenges it faces. This week’s results showed that it remains more efficient than most of its sector peers, with Lloyds reporting a cost-to-income ratio of 47.7%. This shows that the company’s strategy of asset disposals and cost reduction in previous years has made a positive impact on its financial performance. It also provides Lloyds with a competitive advantage over its peers should the UK economy endure a difficult period.

Safety margin

Of course, any sector that could experience difficulties is likely to become unpopular among investors. Banking is no different, but even taking this into account, Lloyds’ valuation offers an exceptionally wide margin of safety. For example, it trades on a price-to-earnings (P/E) ratio of just 7.7 using this year’s forecast earnings. Even when next year’s fall in the bank’s bottom line of 11% is factored-in, Lloyds’ P/E ratio is expected to rise to just 8.6.

Such a low valuation shows that many investors believe that Lloyds is dead and buried. Yet Lloyds is a major UK bank with that very appealing cost-to-income ratio and therefore deserves to be valued as such. However, it’s being valued as a company which is in the middle of extremely poor performance. Certainly, profits could come under pressure and Brexit may dampen the performance of the UK economy. But Lloyds has a brighter future than its current valuation suggests.

Furthermore, Lloyds remains a very sound income stock. Dividend growth forecasts have been reduced in recent months as the outlook for the UK economy has deteriorated. Despite this, Lloyds is forecast to yield 6.2% next year from a dividend that’s due to be covered 1.9 times by profit. This shows that Lloyds’ bottom line difficulties may not cause a reduction in its prospective dividend. Moreover, in the long run there’s scope for brisk dividend rises given the headroom it has when making current payments.

While Lloyds faces an uncertain future, its risk profile isn’t particularly high thanks to its wide margin of safety. Its downside risk may be limited and its capital growth prospects are substantial. Alongside a stunning yield, this makes Lloyds a buy at the present time, in my opinion.

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Peter Stephens owns shares of Lloyds Banking Group. 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.