Can Lloyds Banking Group PLC Double Again?

It has been a good year so far for Lloyds Banking Group PLC (LON:LLOY) — how much more is left?

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Lloyds Banking Group‘s (LSE: LLOY) (NYSE: LYG.US) shares are up 34% on the year and have more than doubled over the past 12 months, but the shares still trade at just one times book value (the reported value of assets less liabilities) — one-third their level in 2007.

So do they have further to go? That is the million pound question, isn’t it?

Let’s look at the basics of banking to try to find the million pound answer.

Easy peasy

Banking is a simple business at its core. A bank just needs some deposits from someone with too much money so it can lend on to someone with too little.

Of course, the interest it receives from this lending needs to be higher than the interest paid on the deposits if the bank (and we as shareholders in that bank) is to make any money. The spread between these numbers is called the net interest margin.

So at its most basic, there are two ways for a bank to grow earnings: improve its net interest margin or increase its lending.

Currently, Lloyd’s net interest margin at its core banking operations (the stuff they plan to keep going in future years) is 2.32%, which is down from 2.42% a year ago (they call that 0.1% drop a 10 basis point decline in the biz), so that is going the wrong way.

The bank’s core loan portfolio dropped from £453.8 billion at the end of the first quarter of 2012 to £430.4 billion on 30 March 2013. Again, going the wrong way for earnings growth.

Not so black and white

Of course, in the complicated world we live in, there are other items that impact a bank’s earnings. The big one we’re concerned about is actually getting paid back by borrowers. This might seem like a simple thing, but banks have proven to have a hard time with this in recent years.

But they’ve been getting better after the disastrous years of 2008 and 2009 and writing off bad loans has generally cost them less and less each year since, which has provided what I’d classify as an artificial boost to earnings — earnings have been growing, but not for the two fundamental reasons we would expect them to.

Banks have also been cutting costs (mainly by cutting staff) to help earnings, but there is a limit to how far this can go (though I’m sure some would argue there will always be too many bankers) and should also come to an end shortly.

Pretty soon the reduction in write-downs will come to a stop and Lloyds (and all the other banks) will have to start writing more loans or improving their margins in order to grow earnings.

Not so easy peasy

But it is hard for a bank to grow its loan book if an economy is struggling — assuming we want them to write profitable loans — and there are some regulatory headwinds for Lloyds, too.

The government is pushing for more competition in the retail banking sector. More competition usually means lower prices — and prices for banks are interest rates – which will likely mean increased or at least continued pressure on margins.

Secondly, the banks are being forced to hold more capital than they previously did. This means they can lend out fewer of their deposits than in the past which will make it harder to grow the loan portfolio.

With these constraints, I find it hard to believe Lloyds will be able to rapidly grow its earnings in the coming years and its ability to pay dividends will be more restrained than in the past.

There is another way

Of course, there is another way Lloyds shares could continue their climb and that is through multiple expansion – investors could lose their fear of banks and what might be lurking within book value and be willing to pay 1.5, 2, 2.5, or even 3 times book value again.

Given the market’s history of short term memory I find it hard to believe this won’t happen again at some point. When, though, is anyone’s guess. Patient investors may be handsomely rewarded at some point.

While you’re waiting for Lloyds to regain the love of the market, you may want to consider looking into one or more of the five companies in this exclusive wealth report from The Motley Fool.

Just click here for the report — it’s free.

> Nate does not own any share mentioned in this article.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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