Towards the end of last year, I called sell on Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US). In my view, the UK-focused bank was already fully valued, and better opportunities were available elsewhere.
Was I wrong?
As an investor, it’s sometimes worth taking a fresh look at a firm’s valuation, in order to try and understand it better.
A classic value investing technique is the PE10 valuation — a version of the P/E that divides a company’s current share price by the firm’s average earnings per share (eps) over the last 10 years.
The PE10 smooths out yearly fluctuations in profits, and can be a good way to highlight good companies that are going through a bad patch.
Lloyds’ PE10 is 3.6!
From 2004-2008, Lloyds made bumper profits. Profits fell in 2009, and the bank reported a loss every year from 2010 until 2013.
However, such were the size of Lloyds’ 2004-8 profits, that even allowing for four consecutive years of losses, Lloyds has ten-year average eps of about 20p, giving a PE10 of about 3.6 — an amazingly low figure.
Is Lloyds a buy?
Lloyds’ finances look fairly strong. The bank’s common equity tier 1 ratio, a key regulatory measure of a bank’s ability to absorb losses, rose from 10.3% at the end of 2013 to 12.0% at the end of September 2014.
City investors tend to view 10% as a key safety level, so this was good news. However, the big question is whether Lloyds’ profits can ever return to pre-crisis levels.
In 2007, Lloyds reported peak annual earnings of 58p per share. I don’t think we’ll see that level of profit again for at least a decade, but I reckon that the bank’s 2008 earnings of 14p per share are a realistic medium-term target.
The latest City forecasts for 2015 suggest Lloyds could report earnings of 8.2p per share this year. If the wider UK economy continues to recover, then I reckon that over the next 2-4 years, Lloyds’ earnings per share could rise to between 10p and 15p.
This would put the bank’s shares on a prospective P/E of between 5 and 7, at today’s share price, suggesting a buying opportunity.
Was I wrong about Lloyds?
I no longer think that Lloyds’ shares are too expensive, but the lack of a reliable dividend is still a problem for me — we don’t yet know when Lloyds will be allowed to restart dividend payments.