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One Burning Question I’d Ask Before Buying Lloyds Banking Group PLC

What is Lloyds (LSE: LLOY) (NYSE: LYG.US) worth, in billions, roughly?

That’s the core of the question I’d want to answer, with satisfactory confidence, if I were considering investing in Lloyds today.

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I’d want to have a decent estimate — but nothing precise to a decimal point — of Lloyds’ intrinsic value as an ongoing business.

In the last few years, the market has placed a variety of wildly differing values on Lloyds. In September 2010, Mr Market’s going rate was £53bn. In November 2011, the asking price had slipped back to £15bn, roughly what it sold for in the crisis year of 2009. Five months ago, according to the market, Lloyds was worth £33bn. Today, Lloyds sells in the market for £53bn once again.

So, what should an investor be willing to pay for Lloyds? Is Lloyds worth £20bn, £40bn, £70bn, £100bn? These are questions a potential investor in any business should want to feel comfortable with. While much has changed, both structurally and in perception, at Lloyds in recent years, the bank’s intrinsic value surely hasn’t jumped around as dramatically as the market’s price. As investors, we need to forget what the market’s latest price is, and focus on what we think the company is really worth.

I think this is exceptionally difficult in the case of Lloyds, not least because any ten year period can produce so many unexpected external risks for banks, more so than most businesses. That’s not recency bias from the last five years — it’s borne out by Lloyds’ record from the 1980s onwards.

Not only are Lloyds’ results leveraged by its huge deposit base, but these results will be highly cyclical, tied to the fortunes of unpredictable markets and economic conditions. Spectacular results and appalling results can be equally hard to predict — and when they come, the potential upside and downside are amplified by the leverage.

Even by simplifying operations and reducing leverage, the slightest changes in a bank’s return on assets will result in more dramatic changes in profits for shareholders. This concern isn’t necessarily one of business risk, but risk in our own judgement. It makes a bank’s earning power difficult to estimate, and results really must be weighed over long stretches of time, ideally the course of a complete economic cycle.

Here we find another stumbling block in our evaluation of Lloyds — it’s very difficult to see what the bank’s structure and its competitive and regulatory environments will look like in several years’ time. It’s equally difficult to look backwards and use past years as a precedent for how much profit Lloyds should be able to earn on its assets, which as previously noted, produces leveraged results for shareholders.

However, even though I’ve put the dynamically changing situation at Lloyds on my ‘too hard pile’, other investors may feel more confident in placing a value on the company. And, certainly, investors have been vindicated so far by backing the state-supported bank. Either way, whether you value Lloyds at £100bn or £30bn, I think it’s always worth answering my original question — “I feel confident this business is worth £Xbn, and that’s why I’m paying the equivalent of £Ybn to own these shares.”

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> Mark does not own shares in any company mentioned in this article.

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