With shares in Lloyds (LSE: LLOY) having fallen by 14% in the last year, it may feel as though things just keep getting worse for investors in the part-nationalised bank. After all, a number of challenger banks have posted stunning gains in the same time period and are reporting superb rises in profitability as well as increasingly efficient business models.
Meanwhile, Lloyds is forecast to report a fall in net profit of 10% in the current year and while it’s expected to return to positive growth next year, only a 2% gain is being pencilled-in by the market. This means that investor sentiment in the bank could realistically come under a degree of pressure in the coming months as the market begins to price-in what are disappointing forecasts at a time when the UK economy is performing relatively well.
Upward rerating due?
However, the extent to which investor sentiment declines could be somewhat limited. That’s because Lloyds’ valuation seems to already factor-in its rather disappointing near-term outlook. For example, it trades on a price-to-earnings (P/E) ratio of just 8.9 using the current year’s forecast earnings. At a time when the FTSE 100 has a P/E ratio of 13, this indicates that an upward rerating is on the cards, with a downward rerating being somewhat unlikely.
Although Lloyds is expected to grow its earnings by just 2% next year and this may not act as a positive catalyst on its share price, its income prospects could do so. That’s because Lloyds is expected to pay a rising proportion of earnings out as a dividend over the next few years. The bank’s payout ratio is due to stand at 54% this year and then rise to 64% next year. This is a generous level of payout compared to most of Lloyds’ banking peers and investors could reward the bank for this via a higher share price.
Certainly Lloyds’ yield indicates that a higher share price is warranted, since it’s currently 6.1%, rising to 7.3% in 2017. That’s considerably higher than the FTSE 100’s yield of just under 4% and indicates that while profit growth may be lacking in the near term, Lloyds could become a much more appealing stock due to its shareholder payout potential.
The right price
Clearly, Lloyds’ financial performance is highly dependent on the outlook for the UK economy. While the potential for a Brexit remains significant and the uncertainty for the global economy is still relatively high, Lloyds’ current valuation appears to provide investors with a sufficiently wide economic moat to merit purchase at the current price level.
Although its performance as a bank may not be particularly inspiring over the next couple of years, Lloyds’ low valuation and scope to raise dividends at a rapid rate appear to be sufficient to make it a buy rather than a sell at the present time.
