2020 was a tough year for many shares, including Britain’s largest bank Lloyds (LSE:LLOY). With many businesses seeing their revenue streams evaporating, the lending firm incurred considerable costs as loan default rates went through the roof.
Today the economic environment has drastically improved. Lockdown restrictions are now over, and companies across the country are slowly getting back on their feet. With debt repayments making their way back to Lloyds’ books, is the group on the verge of experiencing an explosive 2022? Let’s explore.
Are Lloyds shares undervalued?
Looking at the latest third-quarter results for this bank, net interest income came in basically flat, falling by around 1%. However, thanks to the rapid recovery of the economy, the surge in loan impairments experienced in 2020 appear to no longer be a problem.
As a result, profits for the first nine months of 2021 came in at £4.96bn versus £927m a year before. That’s obviously a drastic improvement. But there’s something even more impressive.
In 2020, the last of the regulatory provisions concerning payment protection insurance (PPI) ended. This enabled operating expenses to drop by nearly 30% — a saving that was carried over into 2021. These wider margins are a primary contributing factor to the group’s surge in profits in addition to the eliminated impairment charges.
Consequently, the £4.96bn of profits is actually 219% higher than pre-pandemic levels. And with inflation causing interest rates to climb, Lloyds’ shares look cheap versus its financial performance, in my opinion. It is only trading at a price-to-earnings ratio of 7.8, after all.
Nothing is risk-free
As impressive as the recent financial performance is, there remain some considerable risks. In the near term, a resurgence of the pandemic could once again decimate UK businesses, resulting in further loan impairments.
In the long term, management’s new focus on becoming the country’s largest private landlord opens up a whole suite of new threats. Britain’s housing market has been flourishing in recent years. And with inflation pushing up property values even further, the sector looks like a prudent place to invest.
Yet, I have some reservations. While house prices might be rising at the moment, affordability is going in the opposite direction. Higher interest rates already make mortgages more expensive. But combining this with the end of government support schemes in March 2023, and home sales could experience a significant slowdown.
This, in turn, could send property prices plummeting, along with Lloyds’ future rental revenue. Needless to say, if this were to happen, the Lloyds share price could end up right where it was at the start of the pandemic.
The bottom line
The full-year results for 2021 come out next month. But given the strong performance seen throughout the year in a pre-inflationary environment, I believe this is a stock worth owning, even with the risks. Therefore, I’m tempted to add Lloyds shares to my portfolio while they still look cheap.
