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Although it looks cheap, Lloyds could actually be expensive

I see Lloyds Banking Group (LSE: LLOY) as a bit like a Venus flytrap waiting to capture the unwary investor with the nectar of its high dividend yield. I reckon there’s every chance those buying the firm’s shares because of its dividend could end up disappointed over the long haul as that trap snaps shut!

That may be a colourful analogy, but I believe there are serious risks involved with holding shares in Lloyds that may not be obvious. Justifying an investment on the grounds of the firm’s low valuation could end up getting investors in trouble.

But it looks so cheap!

At the current share price close to 59p, the historical dividend yield stands higher than 5% and City analysts following the firm expect the dividend to move higher during the current trading year and again next year. If things work out as expected, the yield could be around 6% by 2020. And other valuation indicators look low too.

The price-to-earnings ratio is just over nine and is expected to drop to just above seven by 2020. Then there’s the price-to-tangible book value running at close to one. Most indicators you can look at suggest the valuation might be low. But is it? I don’t think so.

My main concern is that Lloyds could be trading close to peak profits for the current economic cycle. Last year’s full-year accounts reveal the firm earned around two-thirds of its income from net interest, with the remaining third from activities such as commercial banking, insurance and wealth management. But I think the one thing all those activities have in common is they can be highly cyclical.

In general, I think the stock market is a clever beast because it represents the opinions and investment actions of thousands of investors, both institutional and private. To me, the current valuation suggests many investors expect profits to cycle lower, as they have done before. If that happens and earnings fall by 50%, say, the current valuation won’t look so low.

But I think the risk is greater than merely a higher valuation. If earnings plunge, there’s a good chance the dividend and share price will follow. Look what happened around the time of last decade’s credit crunch. And before that in the history of the banking sector, crashes are relatively common.

Vulnerable to a downturn in its markets

If you collect dividends from Lloyds for a decade, one good cyclical plunge could wipe out all your good investing work and, to me, that’s a big risk when considering investing in the firm’s shares. A large part of Lloyds’ income comes from the mortgage market and a downturn in that industry, for example, would hit the bank hard.

But it’s easy to become distracted from the cyclical big picture and to get bogged down in over-considering current issues that the bank faces, such as the ongoing payment protection insurance debacle and other matters relating to the banks’ past conduct.

However, I reckon the next crash will likely come just when things look like they’re at their best for the bank. I’m avoiding the shares.

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Kevin Godbold has no position in any share mentioned. 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.