Lloyds (LSE: LLOY) has made an extraordinary comeback since the credit crunch. It has improved the strength of its balance sheet through asset disposals, which have reduced risks and increased potential rewards. Headcount reductions have led to lower costs, which has made the bank more efficient and returned it to a black bottom line. And with a sound strategy through which to deliver improving financial performance, its internal appeal remains strong.
The problem is that its operating environment may deteriorate over the medium term. The global economic growth outlook may prove to be overly optimistic, which could cause Lloyds’ valuation to come under pressure. As such, is it now a stock to avoid?
A changing outlook
In recent months, investors across the globe have become increasingly bullish about the economic policies which may be implemented by Donald Trump. They include lower taxes and higher spending, which may result in higher growth for not only the US economy, but for the world economy too.
But the problem is that there is no guarantee that his planned policies will be implemented. Recently, there have been signs that there may be more opposition to Trump’s policies than was first believed. This could lead to a delay or even change in policy direction, which may cause the financial services sector in particular to experience a difficult period. The cyclical status of banks and their sharp share price rises in recent months mean that their valuations may now be overheated.
As such, the global banking sector may experience a de-rating, while also having the potential of facing a macroeconomic outlook which is not as rosy as previously expected.
With Lloyds trading on a price-to-earnings (P/E) ratio of around 10, its shares appear to be extremely undervalued. Certainly, the have risen by 22% in the last six months and have therefore not missed out on the rally in global banking shares. However, since they started at such a low base, they remain relatively cheap.
This could lead many investors to state that Lloyds is a value trap. Its forecast fall in earnings of 1% in 2018 may be downgraded due to the potential challenges the wider industry faces. As such, the coming months could be tough for the company’s share price.
However, Lloyds appears to offer a bright long-term future for its investors. Clearly, there is some risk in the wider financial services and banking sector, with Donald Trump’s policies creating a degree of uncertainty. However, this could equally create a buying opportunity, since Lloyds offers a relatively low valuation as well as an improving business model. Therefore, its long-term profitability may improve and allow it to justify a much higher valuation.
Although its shares may remain volatile in the short run, a low valuation indicates now could be the perfect time to buy. Lloyds may have failed to surpass 70p per share for most of the last year, but over the next year a significantly higher share price may be on the cards.
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Peter Stephens owns shares of Lloyds Banking Group. The Motley Fool UK has recommended Lloyds Banking Group. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.