I believe the Lloyds (LSE: LLOY) share price is still far too cheap even after rising nearly 200% excluding dividends from its low of 22.2p printed at the end of 2011.
It seems that, to some extent, the market still considers Lloyds to be a recovery play, and it is valuing it as such. But this is an incorrect interpretation of where the business is today and what it has achieved over the past decade.
Indeed, today Lloyds is one of the most efficient and profitable banks in the whole of Europe and barring any significant unforeseen shocks, it is set to continue on this course for the foreseeable future.
Too cheap to pass up?
At the time of writing, the Lloyds share price is trading at a forward P/E of 8.5, a discount of 23% to the broader UK banking sector. In my opinion, shares in Lloyds should trade at a premium, not a discount, to the rest of the sector because it is far more profitable than peers.
According to City analysts, last year it achieved a return on equity (a measure of banking profitability), excluding charges related to payment protection insurance, of 15.6%. For comparison, HSBC, which is the world’s fifth-largest bank, and the largest non-China-based lender, achieved a return on equity of 5.9% for 2017 and only 0.8% in 2016.
Nonetheless, despite the fact Lloyds is three times more profitable than its larger peer, the stock trades at a discount of 33% to that of HSBC.
Management is planning to make Lloyds much more profitable over the next three years. In February the group updated its three-year growth plan targeting profit growth of 25% by 2020 powered by a £3bn digital investment plan and the expansion of its pension, insurance and business lending arms.
Lloyds also wants to cut its cost-to-income ratio to the “low 40s” by the end of 2020, down from 46.8% as reported for 2017 and 48.7% for 2016.
Add all of the above together and it quickly becomes apparent how undervalued the shares are today. Assuming the Lloyds share price valuation remains the same through 2020, if profits grow by 25% as targeted, I calculate the shares could be worth 83p, around 25% above current levels.
If we throw dividends into the mix, the returns are set to be even higher. Analysts are forecasting a dividend per share of 3.6p for 2018 and 3.7p for 2019 excluding any special distributions. These payouts, plus my estimate of a dividend of 3.8p for 2020 and earnings growth, imply a total return of 43% over the next three years.
In the best case scenario, where shares in Lloyds trade up to the same valuation as those of HSBC, I believe the upside could be as high as 108%.
So overall, based on the bank’s current rate of profitability, future growth plans and peer profitability, it looks to me as if the Lloyds share price is significantly undervalued at current levels.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended HSBC Holdings and 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.