Looking at the current price of shares in banking giant Lloyds (LSE:LLOY), they can seem like a real bargain. The price-to-earnings (P/E) ratio, for example, is less than eight.
The Lloyds share price today is 30% cheaper than it was five years ago and a couple of percentage points lower than this time last year. Add in a 4.7% dividend yield alongside management’s stated intention to raise the dividend in future and I understand why Lloyds shares could look very attractive to some investors.
Bank valuations
But what is the right way to value a bank like Lloyds? One is to use the P/E ratio. But the earnings are historical. So if earnings fall in future, the prospective P/E ratio may not be as attractive as it currently seems.
A single quarter of financial results can only ever be a snapshot of a company’s performance. But in its most recently reported quarter, the bank’s statutory post-tax profit fell 27% compared to the same period the prior year. That meant earnings per share, which had been 5.1p in the quarter last year, came in at 3.7p this time around.
That could help explain the fall over the past year. Even so, those are substantial earnings. That 3.7p in one quarter is a lot of profit for a share selling under 50p.
Lloyds is not even the cheapest of the big bank shares using a P/E ratio valuation method. Barclays has a P/E ratio of just 6. NatWest and HSBC are both in single digits, although costlier than Lloyds.
Economic concerns
I think the low valuations across the sector in general reflect the real reason for Lloyds shares being priced where they are at the moment. Investors seem to be marking down the whole sector, based on concerns about how banks may do over the next couple of years.
A worsening economy and expected recession could lead to more customers defaulting on loans. That might lead to bank profits sliding a long way, perhaps in a short period of time.
We saw exactly that happen in the last financial crisis. Indeed, at that point, Lloyds shares fell to trade in pennies. They have never recovered to trade in pounds again as they once did.
But a lot has changed since then, including tougher stress testing for banks’ contingency plans. On top of that, UK banks including Lloyds have yet to report sizeable increases in defaults. So far, the message has been that loan defaults remain at relatively low, manageable levels.
Why I sold my Lloyds shares
If that continues to be the case, I think buying Lloyds shares could yet turn out to be a great bargain. The bank has strong brands and a leading position in the UK banking market. If it sails through the coming years without profits falling much, today’s P/E ratio seems like good value.
The risk I see is that we simply do not know how the economy will perform. I am nervous that a combination of high inflation, increasing interest rates and expensive property prices could end up being unsustainable, leading to higher loan defaults. In fact, that is why I recently sold my Lloyds shares. I reinvested the money in a sector I felt had clearer growth prospects in coming years.