Looking at some common valuation metrics, the price of Lloyds (LSE: LLOY) stock can seem like a bargain. At the current Lloyds share price, for example, the price-to-earnings (P/E) ratio is under 8.
But the shares seem stagnant. The price is within 1% of where it stood a year ago. If it really was a bargain, I would expect investors to pile in, pushing up the price. So, what is going on – and how should I reflect it in managing my shares portfolio?
Strong assets and business base
There is a lot to like about the Lloyds business. It has a strong position in UK banking, owning a variety of financial intitutions including Bank of Scotland and Halifax, as well as Lloyds Bank itself.
It is the largest mortgage lender in the country. Unlike some UK banking peers like HSBC and Barclays, it mostly focuses on the domestic market. That can make it easier for it to benefit from a strong position in one key region. However, it does mean there is a risk that a worsening UK economy could hurt its revenues and profitability.
Worsening outlook
Banking can be a very profitable business in boom times. But when the economy struggles, the industry looks less attractive to me as an investor. If loan defaults rise, profits can drop – sometimes significantly.
With the UK in recession, I see a clear risk this will happen to Lloyds. In its most recent quarter, the company reported post-tax profits 24% lower than in the same period last year.
They still came in at £1.2bn, highlighting the potential of the banking business even in an economic downturn. Still, a 24% fall is large and this was in a quarter when the bank said the flow of assets into arrears, defaults and write-offs was still below pre-pandemic levels. If they start to increase, profits could be eroded even further.
Is the share price a bargain?
So, against that backdrop, does the current Lloyds share price offer me a good value opportunity to increase the banking exposure in my portfolio?
Using the P/E ratio method of valuation, the shares do look cheap. But that may change if earnings decline sharply. I think they may do that.
Using a P/E ratio is only one valuation technique. Many investors use a different approach to valuing bank shares. But even those measures can become less useful in a recession. For example, looking at the price-to-book value can help to show what a bank is worth, but book value is dynamic. If defaults increase, a bank may not be able to rely on repayment of all the loans on which its current book value is based.
I see Lloyds shares as a potential bargain, but not a definite one. Whether they indeed turn out to be a bargain relies on what happens in coming years to the economy and the business’s loan default rates. Although Lloyds is helping itself through applying strict lending standards, a lot of those wider economic factors are outside its control.
For that reason, I have no plans to buy into Lloyds in the current economic environment.
