Whenever I’ve covered the Lloyds (LSE: LLOY) share price in the past, I’ve always concluded that the bank has a bright outlook. Its robust capital position, combined with an attractive valuation and market-beating dividend yield, are qualities that appeal to me as an investor.
However, for some reason, the market continues to view the business with scepticism. So here I’m going to try and establish if there’s something I’m missing here, and if the bank is really worth much less than its current value.
Economic concerns
As Lloyds is one of the largest banks in the UK and the largest mortgage lender, its fortunes are tied to the prosperity of the country’s economy. This turned out to be the bank’s undoing in 2007/08 when the global financial crisis took bankers by surprise. Lloyds found itself struggling to survive as losses mounted and had to ask the government for a bailout.
Even though the firm has come along way since those dark days, there’s still a chance it could come close to collapse at some point again in future. The possibility is relatively small, but it’s still there. A substantial decline in home prices due to economic recession could leave Lloyds nursing huge losses.
Regular stress tests conducted by the Bank of England and other regulators show Lloyds is unlikely to need another government bailout. But, in the worst case scenario, the bank might have to raise additional capital from investors and its dividend will almost certainly be eliminated.
Looking back, the UK economy has suffered a substantial economic decline roughly once every 10 years. On that basis, we are overdue a contraction. I think this is probably the most significant risk overhanging the Lloyds share price today.
We don’t know when the next economic downturn will arrive or the effect it will have on the bank when it does. One thing we do know is that the bank’s income will fall as the Bank of England will likely reduce interest rates to stimulate economic growth and loan losses will rise in a recession.
Further to fall?
If the Bank of England reduces interest rates to zero, Lloyds’ growth will evaporate, and a good deal of its earnings will disappear as well. If you assume earnings fall by 50% from current levels back to 2016’s 2.9p per share, I think the stock could fall as far as 30p. That’s assuming a multiple of 10 times earnings, which is slightly above what the stock is trading at the moment.
That’s the bear argument for the Lloyds share price, and while I don’t think the UK economy will collapse into severe recession anytime soon, I think it’s always worth considering the worst case scenario for any investment.
In the meantime, Lloyds remains, in my opinion, an attractive income stock with its dividend yield of 6% and an attractive valuation of just 7.4 times forward earnings.
