The best instant access Cash ISA available on the market today offers an interest rate of just 1.4%. By comparison, at the time of writing, the Lloyds (LSE: LLOY) share price supports a dividend of more than 6%!
Today, I’m going to explain why I believe this dividend yield is safer than the market thinks, and why I reckon Lloyds could return more than 16% in the near term.
Over the past decade, Lloyds has transformed itself. It’s no longer a struggling financial institution on the brink of bankruptcy. Instead, it’s one of the most stable and profitable banks in Europe. But while it’s worked hard to put past mistakes behind it, until recently, the shadow of the PPI scandal continued to haunt the business.
The good news is banks no longer have to worry about PPI claims denting their bottom lines. The final cost isn’t yet known, and Lloyds has already suspended its share buyback as complaints have been higher than expected this year. But, for the first time in several years, the industry can now start to plan for the future without this hanging over their heads.
Based on past compensation trends, this should unlock several billion pounds of capital per annum for the bank. In total, Lloyds has paid out £20bn since the process began.
Unfortunately, while the PPI scandal has finally come to an end, the spectre of Brexit still looms large. However, I think Lloyds is well placed to deal with economic turmoil that could come with a messy exit. The company’s core capital ratio — a measure of financial strength — was 14.6% at the end of the second quarter, several percentage points above management’s minimum.
What’s more, stress tests conducted by the Bank of England have shown Lloyds has the capital required to withstand the worst-case no-deal Brexit.
So Lloyds’ PPI payouts are coming to an end, which should free up capital, and the bank is prepared for Brexit. This leads me to conclude the outlook for the business doesn’t seem to be as dismal as the market is suggesting.
At the time of writing, its shares are trading at a forward P/E of 7.2 and price to book ratio of 0.8. That compares to 8 and 0.9 for the rest of the banking sector. As mentioned, the stock also supports a dividend yield of 6.2%.
These metrics tell me the Lloyds share price is undervalued and could be worth as much as 10% or more. Combined with the stock’s current dividend yield, shareholders could be on track to see a total return of 16.2% on their money over the next 12 months if Lloyds’ valuation gap with the rest of the sector closes.
Compared to the 1.4% interest rate on offer from the best flexible Cash ISA on the market at the moment, in my opinion this mid-teens return looks too good to pass up.
Rupert Hargreaves owns no 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.