It’s rare to find a stock in the FTSE 350 that trades on a single-digit price-to-earnings (P/E) ratio. It’s even rarer to find one that’s highly profitable and has the potential to grow its earnings and dividends at a rapid rate. However, that’s exactly the circumstances in which Lloyds (LSE: LLOY) currently finds itself, with the part-nationalised bank having the potential to double during the course of 2016.
Clearly, for any stock to double in price requires a significant shift upwards in investor sentiment. And while the UK economy is performing relatively well, the outlook for the global economy remains uncertain due to a slowing China and US interest rate rises. With the EU referendum on the horizon, it would be of little surprise for the UK economy to experience a degree of uncertainty. As such, the 2016 financial performance of banks such as Lloyds is likely to be impressive, but may not benefit from an advantageous macroeconomic outlook to the same extent as in recent years.
That said, Lloyds is still expected to deliver a pre-tax profit of just under £8bn in the current financial year. For a business that until 2013 was deep in the red, that’s an excellent result and shows that its strategy is paying off. On this front, Lloyds’ asset disposals and a ruthless focus on efficiency have led to a relatively low cost-to-income ratio of 48%. And with a lean cost base and scope for improved profitability, there’s the potential for this figure to remain at a highly appealing level over the medium-to-long term.
Dividends on the rise
Due to Lloyds’ improving financial performance, its dividends are expected to rise rapidly. The bank’s shares are due to yield 5.2% in the current year as dividends per share are set to increase from 2.4p last year to 3.7p this time. That’s a gain of 54% in just a year. With the FTSE 100 yielding around 4%, Lloyds is now a very appealing income stock with a sound financial footing through which to increase shareholder payouts at a higher rate than inflation.
With Lloyds trading on a P/E ratio of only 8.5, there’s significant upward rerating potential. Clearly, a rating of 17 may seem somewhat unachievable this year, but Lloyds posted a share price gain of 89% in 2012 and 61% in 2013. Both of these figures show that the bank’s shares can quickly gain in popularity and push its valuation substantially higher. And with Lloyds now in a much healthier position than in 2012 or 2013, it could be argued that even greater gains are warranted after the disappointment of 2014 and 2015.
One potential catalyst to move Lloyds’ shares higher is the sale of the government’s stake that’s due to complete this year. As well as being a good deal for investors (who, when purchasing new shares, will receive a 5% discount to Lloyds’ share price plus a free share for every 10 held for a year), the end of government ownership could finally signal that Lloyds is almost back at full health, thereby boosting market sentiment.
Moreover, when a yield of 5.2%, a discount of 5% and the potential for a 10% bonus (with one free share) are added to the upward rerating potential on offer, a 100% total return in the next year can’t be ruled out.