In my experience, City analysts are generally slow to downgrade company earnings forecasts as a bear market unfolds. Equally, they’re often behind the curve in upgrading earnings as markets and economies recover — that’s to say, they don’t increase their forecasts fast enough or far enough.
Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US) has seen a strong rise in its shares over the past year: they’re up 75%. Investors are often put off after such an increase. However, I’m not interested in the ups and downs of share prices. I’m only interested in the company’s valuation.
While you have to pay 75% more for Lloyds’ shares today than a year ago, the valuation of the company hasn’t increased by anywhere near that much. The reason is that earnings forecasts have also risen — by 45%. Looking at the last three months, the shares have been flat, while analysts have upped their forecasts by 15%.
The trend in earnings forecasts is summarised in the table below.
| Year | Current | 3 months ago | 6 months ago | 1 year ago |
|---|---|---|---|---|
| 2013 | 5.33p | 4.61p | 4.32p | 3.66p |
| 2014 | 6.78p | 5.88p | 5.53p | n/a |
Source: Digital Look
Lloyds’ shares are currently trading at 75p. Based on the forecasts of earnings per share (EPS) in the table, investors are buying at about 14 times this year’s earnings and 11 times next year’s.
With Lloyds having released this year’s third-quarter results last week, there’s probably now little further scope for upgrades to the 2013 full-year forecast. The current EPS consensus of 5.33p shouldn’t be too far away from the reality.
However, if, as I say, analysts are often behind the curve on upgrading earnings, the current EPS consensus of 6.78p for 2014 could well continue to rise, which would make an already attractive earnings multiple of 11 even tastier.
In addition, earnings upgrades would similarly increase the appeal of Lloyds on the so-called PEG ratio. The PEG formula is price-to-earnings divided by earnings growth. A PEG of less than 1 suggests a cheap valuation for the level of earnings growth expected; and the further below 1 the PEG is, the cheaper the valuation.
As things stand, assuming EPS of 5.33p this year and 6.78p next year, Lloyds is on a PEG of just 0.4 for 2014. Upgrades to the 6.78p forecast would push the PEG down even further into bargain territory.