Why buy Lloyds Banking Group plc when you can buy the FTSE 100?

Investing in individual stocks from an index such as the FTSE 100 is riskier than investing in the whole index through a simple, low-cost tracker. Furthermore, if you're not rewarded with higher returns for taking on the higher risk, why bother with individual stocks?

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The table below shows total returns (capital + dividends) delivered by Lloyds(LSE: LLOY) and by three widely-tracked indexes of which Lloyds is a constituent.

As you can see, Lloyds has delivered very disappointing returns relative to the indexes over the short term (one year), medium term (five years) and long term (10 years).

Is it time to send the Black Horse to the knacker's yard and buy trackers instead, or is the old nag set to put its poor form behind it and become an index outperformer?

Valuation

The FTSE 100 is currently trading on a trailing price-to-earnings (P/E) ratio of almost 33 -- around double its long-term historic average. This suggests that the index may struggle to advance until corporate earnings rise significantly across the board. As such, now could be a good time to seek out cheap individual stocks.

Is Lloyds such a stock? Well, the bank's trailing statutory earnings per share (EPS) is 0.2p, which, at a share price of 65p, gives a P/E of 325! However, on an underlying basis, we're looking at a bargain-basement stock: underlying EPS of 8.1p gives a P/E of just 8 -- half the FTSE 100's long-term historic average. This suggests that there's scope for the shares to rerate markedly higher as the legacy issues that have been depressing statutory EPS recede.

Growth prospects

As you might expect with a stock trading on a P/E of 8, the near-term outlook for earnings growth isn't too bright. Analysts expect Lloyds' underlying EPS to fall to 7.6p this year. This gives a prospective P/E of 8.6, which is still very cheap compared with the FTSE 100's forward long-term historic average of 14.

Dividend potential

The trailing dividend yield of the FTSE 100 as a whole is 4.1%. Dividend cover of just 0.75 is unsustainably low, so the dividend return from the index is under pressure. In contrast, Lloyds' trailing dividend of 2.75p (including a 0.5p special), giving a yield of 4.2%, is well-covered by underlying earnings.

Furthermore, analysts expect the dividend to march higher this year, while still being well-covered. Forecasts are for a 4.2p payout, covered 1.8 times, giving an attractive yield of 6.5%.

Opportunity?

Lloyds is in the final stages of recovery from the financial crisis. The delay in the government's sale of its remaining 9% stake, due to this year's volatile market, and current uncertainties, such as the outcome of the Brexit vote, have held the shares back.

However, this could be an opportunity. The current cheap earnings rating and high dividend yield could help Lloyds reverse its record as an index underperformer and deliver an above-average return in the coming years.

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G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.