At 50p, are Lloyds shares still undervalued?

Lloyds shares are up 13% over the last month. But Stephen Wright thinks the bank’s returns on equity mean it could still be undervalued at today’s prices.

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Investors who bought shares in Lloyds Banking Group (LSE:LLOY) a year ago have done very well for themselves. The stock is up almost 13% over the last 12 months.

The Lloyds share price has broken through the 50p mark and isn’t showing any obvious signs of slowing. So is the stock still one for investors to consider buying?

Business performance

The value of any stock is a function of how much cash the underlying business generates. And after a strong performance in 2023, Lloyds shares look like a bargain at a price-to-earnings (P/E) ratio of 6.5.

Assessing the intrinsic value of the stock is more complicated than this though. There are a few reasons the company’s earnings are likely to be lower going forward than they were last year.

In 2023, Lloyds benefitted from a one-off loan repayment and higher interest rates supporting wider lending margins. But neither of these is likely to be repeated next year.

The question for investors then is what sort of profits the bank is likely to generate over the coming years. And there are a few clues investors can fasten on to.

Returns on equity

One of the best ways of gauging profitability for banks is the return on equity metric. This measures how efficiently the organisation is able to use its capital to generate income.

Last year, Lloyds managed a return on equity of around 12%. An indication of how unusual this is comes from the fact that its 10-year average is just over half this, at 6.6%. 

While interest rates have been higher than normal of late, they’ve been unusually low over the last decade. So a 6.6% figure might be conservative as an estimate of the bank’s earnings potential.

Management’s optimistic that it can maintain its strong returns for at least another year though. So does this mean the stock’s undervalued at today’s prices?

Valuation

Right now, Lloyds shares trade at a price-to-book (P/B) ratio of 0.7. From this we can model what profits might look like if the company achieves different returns on equity over the next 10 years.

Going forward, it seems unlikely that returns on equity are going to be lower than 6.6% – the average over the last decade. They may fall below this in any year, but I’d expect the average to be higher.

A 6% return on equity implies an earnings yield of around 9.5%, which translates to a P/E ratio of just over 10. At that level, the stock’s valuation is roughly in line with the average for the FTSE 100.

In other words, even if interest rates depress margins as much as they have over the last 10 years, I think Lloyds can do well enough to justify its share price. And it has plenty of scope to do better.

Should I buy the stock at 50p?

After a 13% rally, perhaps the time to buy Lloyds shares has passed. But I don’t think so. The main risk with the stock — lower interest rates weighing on margins — is remains an issue. But it could be said to be priced in.

Lloyds shares still look undervalued to me. The equation isn’t as favourable as it was a month ago, but it still looks good, even with the stock above 50p.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Stephen Wright has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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