With profit rising by 163%, Lloyds (LSE: LLOY) appears to be an obvious buy. After all, it is rare to find a FTSE 100 stock which offers such a high growth rate. However, the 163% rise in earnings is on a reported basis, with its underlying performance being far less impressive. In fact, the bank’s underlying profit fell by 3% versus 2015. Could this indicate that it is a stock to avoid, rather than buy, at the present time?
Improving performance
While Lloyds’ underlying profit was lower than in 2015, the bank has nevertheless made significant progress. It continues to be among the most efficient banks in the sector, as demonstrated by its cost-to-income ratio of 48.7%. This indicates that the ferocious cost-cutting of recent years is starting to bear fruit. And since Lloyds has been able to reduce operating costs by 3%, it seems as though there could be more efficiencies to come as it targets a cost-to-income ratio of 45% within two years.
In addition, the bank’s common equity tier 1 (CET1) ratio improved to 13.8%, which is a rise of 80 basis points versus a year ago. This helped it to perform well in recent stress tests when compared to its UK-listed banking peers. As such, if Brexit does create a difficult trading environment for the wider sector, Lloyds could prove to be a less risky option than many of its rivals. Furthermore, asset quality remains strong, with there being no deterioration in the underlying portfolio during 2016.
Outlook
Lloyds also announced a 13% rise in dividends, as well as a special dividend of 0.5p per share. This means it yielded around 4.4% in 2016, which indicates it is quickly becoming a must-have income share. Given its dividends are covered almost twice by profit, there seems to be scope for a rise in shareholder payouts over the medium term.
The company’s valuation also indicates that now could be the right time to buy a slice of it. Lloyds currently trades on a price-to-earnings (P/E) ratio of just 10, which suggests there is scope for a major upward re-rating. Although this may not take place in 2017, as the market is forecasting a fall in the company’s earnings of 4% in 2018, over the medium term it would be unsurprising for a P/E ratio which is 30% or higher to be applied to the bank’s shares. After all, it has a solid balance sheet, is highly efficient and is becoming relatively well-diversified.
Brexit challenges
Clearly, the company faces a significant risk from Brexit. The two-year negotiation period is due to start shortly and this may lead to more difficult trading conditions for banks and a number of other sectors in the coming months. However, Lloyds has made huge progress in 2016 and in recent years. It appears to be one of the most attractive banking stocks to own due to it having a wide margin of safety and a considerable economic moat. Therefore, while volatility may edge higher this year, now seems to be the perfect opportunity to buy it.
