Is this Neil Woodford pick a better buy than Lloyds Banking Group plc?

Neil Woodford’s £9.4bn Equity Income fund has a £128m stake in global security provider G4S (LSE: GFS). But Mr Woodford expects the value of these shares to rise significantly in the future.

Woodford’s August fund update made special mention of G4S’s interim results, which beat analysts’ forecasts. G4S shares have risen by 24% since the firm’s results were published on 10 August. The fund’s view is that G4S has “strong long-term growth prospects in emerging markets.” G4S’s strong cash flow and global diversity are being undervalued by the market, according to Woodford.

An attractive valuation?

G4S’s revenue rose by 5.1% to £3.1bn during the first half. Earnings were 13.3% higher at £102m, while operating cash flow rose by 51.8% to £293m.

The shares trade on 15 times forecast earnings and offer a prospective dividend yield of 4%. With earnings per share expected to rise by 14% in 2016 and by 12% in 2017, this valuation seems attractive.

The main risks relate to debt. Net debt was £1,782m at the end of June, giving a net debt/EBITDA ratio of 3.2 times. That’s pretty high. The group is targeting a level of 2.5 times over the next 12-18 months, and I’d say this is key to the investment case. In my view, debt needs to fall for the dividend to stay safe.

I agree that G4S could be a good long-term buy from current levels. But personally, I’d like to see debt start to fall before putting my own cash into this stock.

Do Brexit risks make Lloyds a sell?

In contrast to G4S, Lloyds Banking Group (LSE: LLOY) has much stronger balance sheet than it did a few years ago. The bank’s Common Equity Tier 1 (CET1) ratio of 13% is among the highest of all the big UK banks.

Dividend payments are rising fast and are expected to total 3.12p per share this year, 13% more than was paid last year. This gives a forecast yield of 5.5%, which seems fairly attractive.

The only problem is that analysts have slashed their dividend forecasts for Lloyds since the EU referendum. Three months ago, the City expected Lloyds to pay a dividend of 4.24p per share for 2016. That forecast was cut by 26% to 3.12p after the bank warned that “capital generation may be somewhat lower in future years than previously guided.”

In other words, Lloyds doesn’t expect its operations to generate as much surplus cash as expected. Earnings per share are now expected to fall by 14% to 6.36p per share next year.

I believe this weaker outlook is one of the main reasons why Lloyds shares currently trade on a 2016 forecast P/E of just 7.7. The market isn’t confident in Lloyds’ ability to continue generating reliable profits from mortgage lending and high street banking.

The question for us is whether this pessimistic outlook is being overdone. Will the housing market crash? Will Lloyds mortgage profits crumble?

It’s hard to say. My view is that Lloyds is probably quite cheap at the moment. But I’m cautious about the housing market. I don’t see any rush to buy a banking stock with falling earnings and an uncertain outlook.

Will Brexit hurt Lloyds and G4S?

The UK's Brexit vote has created an uncertain outlook for many domestic businesses. Lloyds may be more exposed than G4S, which generates a lot of revenue overseas.

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Roland Head 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.