Lloyds (LSE:LLOY) shares have resolutely failed to ignite in recent years. The average brokerage target on them is 60.7p. That’s 41% higher than the current share price.
So, how do we explain this discrepancy? Surely it’s one of the most undervalued stocks on the FTSE 100?
Valuation
Lloyds trades at 5.2 times earnings, making it one of the cheapest banking stocks operating in developed nations. It also trades around 5.3 times forward earnings, that because analysts are expecting the performance to decline slightly in the second half of 2023.
In 2022, Lloyds achieved earnings per share (EPS) of 7.3p. Looking forward for the FY23, analysts expect EPS of 7.18p. Personally, I see it coming in a little higher after the bank achieved 3.9p in the first half of the year.
Looking further into the future, analysts anticipate its EPS to come in at 7.3p in 2024 and 8.23p in 2025. This is a positive forecast, likely driven by interest rates returning to the so-called Goldilocks Zone — the ‘just right’ level somewhere between 2% and 3%.
Tailwinds and headwinds
So, how do we explain the 41% difference between the average target price and the current price, especially when Lloyds is forecast to perform better in the coming years.
Well, it’s because higher interest rates bring headwinds as well as tailwinds. Of course, higher rates means net interest income has been pushing upwards. This can work on a lag as many households are on fixed-rate mortgages and higher rates haven’t filtered through to them yet.
But it’s also the case that higher interest rates can lead to more defaults. In turn, this means higher impairment charges as credit losses mount. Impairment provisions have been rising, but with a higher-for-longer interest rate position, there could be more pain.
Nonetheless, to date, higher interest rates have been a net positive for banks. This could change, of course, especially if the UK economy experiences a hard landing — Lloyds is exclusively focused on the UK market.
That’s one of the negatives. As Lloyds doesn’t have an investment arm, it’s more interest-rate-sensitive than other banks, which isn’t always a good thing. In other words, it’s less diversified than its peers.
This is why the Lloyds share price rises and falls so sharply on single pieces of economic news. When there’s evidence that inflation might be slowing, and therefore further reinforcing the idea that interest rates have peaked, Lloyds tends to push up.
And this happens in reverse when inflation comes in hot or we see negative forecasts for the UK housing market.
My position
I’ve been topping up on Lloyds shares. For me, the risk of a moderate increase in impairments has been more than priced in. The stock looks incredibly cheap at just 5.2 times earnings and 0.72 times book value — the company’s share price relative to net asset value. Moreover, with a 5.7% dividend yield, Lloyds looks well-positioned to provide strong returns.
To answer my original question, could we see Lloyds shares double in value? In the near-to-medium term, it’s unlikely. But looking at its valuation relative to the sector internationally, which has an average P/E around nine, it’s certainly possible to see the stock extend to 60p soon.
