Is There 80% Upside in Lloyds Banking Group plc?

When it comes to valuation, there are so many ways to measure the worth of any given company and some would argue it’s more of an art than a science.

Today, I’m running  Lloyds Banking Group plc (LSE: LLOY) shares through Benjamin Graham’s Rule of Thumb valuation technique and finding that they could offer prospective investors real value at current prices. The technique was designed by the father of value investing to simplify the more complex Discounted Cash Flow method.

Doing the math

First, certain assumptions are required in order to perform the analysis, as the whole topic of stock valuation is forward-looking. Also understand that the final stock value will vary based on the assumption of scenarios.

Instead of trying to pinpoint one number, the science behind valuing stocks is to come up with a range of values to help you think about the downside as well as the upside.

The original formula from Security Analysis was:

V * = EPS x (8.5 + 2g)

Here V is the intrinsic value, EPS is the trailing 12-month EPS, 8.5 is the PE ratio of a stock with 0% growth and g is the growth rate for the next 7-10 years.

The formula was later revised as Graham included a required rate of return.

V * = EPS x (8.5 + 2g) x 4.4 / Y

What differs is the number 4.4. That’s what Graham determined as his minimum required rate of return. At the time (1962) when he was publicising his works, the risk-free interest rate was 4.4%. To adjust for today, divide this number by the AAA corporate bond rate, represented by Y in the formula above.

Running the numbers

I’m running the figures through the Stockopedia valuation tool where I can adjust them with a view to being slightly conservative and letting the computers do the hard work.

First, I input the Earnings Per Share (EPS). While there’s no specific guidance as to the best figure to use, I prefer the 2014 normalised EPS figure of 3.74p. Yes, there are other options, like forecast earnings, but this risks double-counting growth and relies on analysts who aren’t always accurate.

Next, I input the medium term growth rate, not easy for Lloyds given the impact of the financial crisis on earnings. So I’m choosing a conservative 15%, significantly below expected growth for this year, but smooths things out over the medium term.

Third comes the growth multiplier. Again, I’m being conservative for an extra safety layer and reducing it to 1.5 instead of the 2 in the original formula.

Finally, I input the yield on a 20-year AAA corporate bond. According to Yahoo Finance, this is currently 3.88%. The figure can be adjusted according to the risk profile.

And the result? Believe it or not, this gives an implied value of 131.48p – some 80% higher than Friday’s closing price. Yes, valuation may be more of an art than a science, but Lloyds looks cheap on other metrics too. The forecast 12-month rolling P/E is under 10 times earnings and the shares are forecast to yield 5%. And the price to tangible book value is just 1.07, making it unlikely that you’re currently paying over the odds.

Undervalued = opportunity

As you can see from the chart below, Lloyds shares have come off recent highs and underperformed the market of late – perhaps it’s a good time to take a position in a UK banking giant that could be seriously undervalued.

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Dave Sullivan has no position in any shares mentioned. 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.