It is quite clear that the Lloyds Banking Group (LSE: LLOY) share price is undervalued.
At the time of writing, the stock is dealing at a forward price-to-earnings of just 9.4 and a price to book ratio of around 0.96. These metrics might make sense if the bank was struggling to make a profit, but that is not the case.
Booming bottom line
City analysts are expecting Lloyds to report a net profit of £5.2bn for 2019 and a similar level of profitability for 2020. Management is forecasting return on tangible equity – a key measure of profitability in the banking sector – for 2019 of 12%, down from the previous estimate of 14% to 15%, due to a late surge in PPI claims.
These metrics make Lloyds one of the most profitable large banks in Europe.
Some of its close peers, including HSBC, Deutsche Bank, and Credit Suisse, all of which have more significant global operations and substantial investment banks, are set to report returns on tangible equity of between 7% and 10% for 2019, after adjusting for one-off costs.
With this being the case, I think it is best to compare Lloyds to its US peers, which are reporting a similar level of profitability to the UK-based lender.
US banks are currently dealing at an average price-to-book ratio of 1.3 and P/E ratio of 12.5. On this basis, it looks as if shares in Lloyds are undervalued by around 30%. This implies that the stock is worth about 90p according to my figures.
The Brexit question
The big question is, why is the market placing in such a substantial discount on shares in Lloyds?
It seems that there is one main answer to this question, and that is Brexit. The market appears to be worried about the possible impact of economic turmoil from a rough divorce on the bank.
However, over the past few weeks and months, there seems to have been a change in sentiment towards Lloyds and the rest of the UK banking sector.
Ever since Boris Johnson and his team managed to negotiate a new withdrawal deal with the EU, shares in Lloyds have been on fire. The stock has jumped nearly 15% excluding dividends since the beginning of September.
These moves suggest that if we have further positive news on the Brexit front, the stock could rise further. And if a full deal is agreed, avoiding a no-deal altogether, then I reckon the Lloyds share price could soar to 90p.
While you wait
It could be some time before we get this news, but in the meantime, investors can look forward to Lloyds’s market-beating dividend yield of 5%. The payout is covered twice by earnings per share, so even if the lender’s profits decline 2020, it looks as if there’s plenty of headroom for management to maintain the distribution and continue to reinvest in the business.
