Why I believe the Lloyds share price is now too cheap to ignore

The Motley Fool

High street stalwart Lloyds Banking Group (LSE: LLOY) seems to be one of the most hotly-debated stocks in the FTSE 100.

Depending on who you believe, this bank is either an unbeatable dividend buy or an overvalued business where profits are about to slump.

At the heart of this debate is your view on the outlook for the UK economy. Investors such as fund manager Neil Woodford and my Foolish colleague Alan Oscroft believe that Lloyds is a compelling long-term income buy at current levels.

On the other side of the fence, my fellow Fool Kevin Godbold is keen to emphasise the risk of investing in a cyclical stock when profits are high. And despite avoiding banking stocks for the last five years, fund manager Terry Smith's Fundsmith Equity Fund rose by 175% from 2012-2017, outperforming the 135% gain delivered by Lloyds over the same period.

3 reasons why I'd buy

No stock is completely free of risk. But I think there are some clear signs suggesting Lloyds shares are attractively priced at the moment, despite the risk of a slowdown in consumer spending.

I also believe that the banking sector in general is still in a fairly early stage of recovery, with further gains likely.

Here are three reasons why I'm bullish about Lloyds stock.

1. Rising interest rates

The US Federal Reserve raised interest rates by another 0.25% yesterday. Comments from the Bank of England suggest that another rate rise is likely here in May.

After eight years of ultra-low rates, we don't know exactly how higher rates will affect the economy or banking profits. But higher rates are generally expected to increase banks' profitability.

2. Returns are still low

A key measure of profitability for banks is return on tangible equity. Lloyds reported a return on tangible equity of 8.9% last year, up from 6.6% in 2016. This is a worthwhile improvement, but it's still relatively low. The bank expects this figure to rise to between 14% and 15% in 2019.

Most of the other big UK banks are also targeting figures of 10% or more. I think it's reasonable to expect further gains, which could have a big impact on profits.

An affordable valuation

Lloyds' forecast P/E of 8.7 might seem cheap, but if profits fall, that ratio could rise fast. That's why I also like to value banking stocks against their tangible book value. Lloyds reported tangible net assets per share of 56.5p at the end of last year.

That puts the stock on a price/tangible book ratio of about 1.2. That's not expensive for a profitable and healthy bank.

Although the value of Lloyds' assets could fall if bad debt levels rise among its mortgage and credit card customers, impairment rates actually fell last year. It's also worth remembering that lending standards have generally been tightened since the financial crisis. This should reduce the risk of major problems.

Why I'd buy

I believe that Lloyds' shares offer good value at the current level, especially for income investors attracted by the forecast dividend yield of 5.5%.

Even if the UK economy does slow down, I don't think another 2008/09-style meltdown is likely. I'd be happy to buy this stock for income, using any future downturn as an opportunity to average down and improve my dividend yield.

Buy-And-Hold Investing

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.