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Why I Like Lloyds Banking Group PLC Despite £500m Rise In PPI Costs

Today’s update from Lloyds (LSE: LLOY) has sent the bank’s shares lower by almost 5%, with the additional provision of £500m for PPI claims grabbing headlines. Clearly, this is bad news for the company’s investors, since it shows that Lloyds’ improving financial performance is being eaten away at by a seemingly never-ending charge. And, with Lloyds having set aside almost £14bn to date for PPI claims, it is £14bn of cash which could have been used to pay dividends or bolster the bank’s capital ratios.

However, PPI claims will not last forever. The FCA has said that it is mulling over a deadline for new claims, which would mean that within a couple of years Lloyds would not need to keep setting aside cash to repay disgruntled customers. As such, today’s provisions may be disappointing, but should not detract from the bank’s improving financial performance.

For example, Lloyds announced today that underlying profit increased by 6% in the first nine months of the current year versus the same period last year. A key reason for this has been continued improvement regarding the bank’s costs, with operating costs falling by 1% despite additional investment and simplification costs being undertaken. This has meant that Lloyds now has a cost:income ratio of just 48%, which is ahead of many of its UK-focused peers.

In addition, Lloyds reported a fall in impairment charges of 64%, with its asset quality ratio also improving by 15 basis points to 0.11%. And, while other income was weaker than expected in the third quarter of the year, Lloyds has still be able to deliver underlying return on equity of 15.7%, which is up 170 basis points on the first nine months of 2014. And, with the bank’s common equity tier 1 ratio continuing to rise and now standing at 13.7% versus 13.3% in June, it appears to be in a strong position to capitalise on the continuing robust performance offered by the UK economy.

Clearly, Lloyds is moving in the right direction and, while there will inevitably be lumps and bumps along the way (such as today’s £500m PPI provisions), its current valuation appears to adequately take this into account. For example, Lloyds trades on a price to earnings (P/E) ratio of just 8.6 which, for a highly profitable business which is delivering improved financial performance, is difficult to justify.

In addition, Lloyds is due to yield 5.3% next year as it continues with its aim of increasing the dividend payout ratio to up to 65% of profit. If it were to reach this level of payout then it could be yielding as much as 7% per annum over the medium term, which may make it one of the most appealing income plays in the FTSE 100.

And, with there being an opportunity to buy at a 5% discount to its current share price and receive an additional share for every ten purchased (subject to a one-year holding period) via the government’s retail offer next year, Lloyds looks set to be a hugely profitable investment in the coming years.

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Peter Stephens owns shares of Lloyds Banking Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.