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Why I see 20%+ upside in this lender in 2017

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The outlook for the lending industry is somewhat uncertain. Brexit is likely to cause a degree of difficulty as negotiations between the UK and EU commence. This could cause a further fall in sterling, higher inflation, and more challenges for consumers in servicing their loans. Alongside tougher rules on buy-to-lets, this may make 2017 a difficult year for lenders. However, today’s results from one lending company indicate there is at least 20% upside in its share price.

An upbeat performance

Paragon Group of Companies (LSE: PAG) has delivered underlying operating profits for the quarter ending 31 December which show that it’s making encouraging progress. They were in line with management expectations and were supported by sound underlying trends in volumes, cost control, bad debts and margins.

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Significantly, each of the company’s lending and investment entities generated quarter on quarter volume growth, with total originations and investments of £380.7m versus £254.4m in the previous quarter. This was despite a tightening on rules concerning buy-to-let, which saw lenders toughen up criteria ahead of the Prudential Regulation Authority’s (PRA) underwriting changes.

Difficult outlook

As mentioned, trading conditions for lenders could worsen. The affordability of debt may decline if inflation pushes higher and wage growth fails to at least match it. However, Paragon has a sound funding position and its capital ratios remain relatively high. For example, it has a core equity tier 1 (CET1) ratio of 16.1%, while free cash balances of £269m should be able to support future growth.

The company’s forecasts are somewhat mixed. In the current year it is forecast to record a rise in its bottom line of 3%, but then deliver earnings growth of 10% next year. While this compares unfavourably to the outlook for other lenders, such as Standard Chartered (LSE: STAN), Paragon has a far less demanding valuation. For example, Standard Chartered is expected to record a rise in its net profit of 137% this year, followed by 54% next year. However, its price-to-earnings (P/E) ratio of 19.9 is more than double Paragon’s rating of 9.8.

Share price potential

In terms of the scope for a 20% rise in Paragon’s share price, its valuation suggests this will not be particularly difficult to achieve. Its low P/E ratio is difficult to justify, given that it expects to post double-digit growth next year. Therefore, a rating of 12 would give a share price gain of 23%. This appears to be realistic target and would leave it with a price-to-earnings growth (PEG) ratio of only 1.2.

Of course, Standard Chartered’s PEG ratio of 0.2 indicates it has substantially greater share price potential than its lending peer. As such, it appears to offer a superior risk/reward ratio – especially in the long run as it takes advantage of its strong position in Asia to deliver high growth rates. However, I believe that Paragon remains a sound buy that’s financially strong and which has upside of over 20%.

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Peter Stephens owns shares of Standard Chartered. 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.

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