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Is this challenger bank set to overtake Lloyds Banking Group plc?

The UK banking scene has changed immensely in the last decade. Back then, established banks such as Lloyds (LSE: LLOY) dominated most areas of the industry – especially the mortgage market. This led to a lack of choice for consumers – and for investors. Furthermore, since the sector was severely hurt by the credit crunch, investors have been left with a great deal of uncertainty in recent years.

Challenger banks

Today though, there is much greater choice for everyone. Challenger banks have been encouraged by the government and regulator in order to provide much-needed competition within the sector. Banks such as Virgin Money (LSE: VM) have managed to generate rising sales and improving financial performance. For example, in the last financial year its earnings increased by 28% and it is forecast to deliver double-digit growth in each of the next two financial years. This compares to a forecast fall in profit for Lloyds in 2018.

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Not only does Virgin Money offer strong earnings growth, it lacks the legacy issues of its sector peer. It is a relatively simple business model and is perhaps more akin to a ‘traditional’ banking operation, in terms of offering savings and mortgage products as its core products. By contrast, Lloyds and its well-established peers have diversified into other product areas, while it remains a part-nationalised bank. Although this may not have held back investor sentiment to a large amount of late, it nevertheless means greater uncertainty for the bank’s investors.

Valuation

As well as being a more straightforward bank, Virgin Money also has a lower valuation than Lloyds. It has a price-to-earnings (P/E) ratio of only 8.7, while its sector peer has a rating of 9.1. In both cases, there is clear upside potential from a higher re-rating. Since Virgin Money has a price-to-earnings growth (PEG) ratio of 0.6, it seems to offer the more obvious capital gain potential at a time when the earnings of its industry peer are forecast to fall.

However, Lloyds may have stronger catalysts to push its share price higher. The government’s stake may have been a drag on its share price, but its sale is imminent and this may boost the bank’s total returns. Furthermore, Lloyds continues to make improvements to its business model and is gradually returning to full health. This could encourage a higher valuation, as investors may see it as a new era for the bank following the post-credit crunch difficulties.

Looking ahead

For income-seeking investors, Lloyds has much more obvious appeal. It yields 5.7% versus Virgin Money’s 2.1% yield. With inflation moving higher and expected to rise to as much as 3% or 4% by 2018, a higher income return could be a key differentiator between the two companies.

Certainly, Virgin Money looks set to deliver a rising share price due to its impressive forecasts and low valuation. However, with a size and scale advantage, as well as the potential for improved financial performance under fully public ownership (as opposed to part-government ownership), Lloyds appears to be the more enticing long-term investment option out of the two stocks.

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Peter Stephens owns shares of Lloyds Banking Group. The Motley Fool UK has recommended Lloyds Banking Group. 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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