Even the best companies are only a good investment if the price is right. Does Lloyds Banking Group (LSE: LLOY) fit this requirement? At 65p, the bank's shares trade on a 2016 forecast P/E of about 8.5 and offer a forecast yield of 6.6%.
This certainly seems cheap enough. The long-term average total return from the stock market is about 7% each year, so Lloyds' chunky forecast dividend yield means that the share price would only need to rise by a few pence for the bank to deliver market-beating returns.
I've been taking a closer look at Lloyds' first-quarter trading statement, and believe the bank's figures hint at an underlying quality that could help deliver big profits for investors.
Lloyds reported a net interest margin of 2.74% at the end of the first quarter, up from 2.64% at the end of last year. That's quite a high profit margin for a big bank.
Another key measure of profitability for banks is return on equity. All banks quote several versions of this figure, but Lloyds underlying return on required equity of 13.8% compares very well to the sub-10% underlying returns managed by the other big UK banks.
Lloyds' returns are boosted by its low costs. During the first quarter, the bank's operating costs consumed just 47% of its income. Royal Bank of Scotland Group, in contrast, reported a cost: income ratio of 76%!
Low costs have probably helped Lloyds to build up its Common Equity Tier 1 (CET1) ratio to 13.0%, one of the highest figures in the sector. This should mean that the bank can cope with a downturn in asset prices -- such as a housing market crash -- without needing to raise fresh cash.
A simple value that does make sense
Bank's accounts are very difficult to understand. Perhaps the easiest metric for private investors to follow is tangible net asset value per share. This is the market value of a bank's net assets, excluding intangible items such as brand names.
Lloyds' tangible net asset value per share is currently 55.2p. Today's 65p share price represents an 18% premium to tangible asset value. While value investors (including me) often look for shares trading at a discount to their asset value, this premium could actually be a good sign for investors.
A healthy and profitable bank will normally trade at a premium to its tangible asset value, as Lloyds does. This valuation is the market's way of saying that it trusts the quality of the bank's assets and expects them to deliver acceptable returns.
When a bank's shares are at a discount to their tangible asset value, the market is questioning the bank's ability to generate a return on its assets.
What happens next?
The latest broker forecasts suggest that after rising strongly this year, Lloyds' profits will be flat in 2017.
My view is that Lloyds' earnings are unlikely to stay flat forever. I think that the shares are probably cheap enough to be a good buy for income-seeking investors. Although there is a risk that Lloyds' profits will stagnate, I suspect that locking in a 6.6% yield today may look smart in a few years' time.
If you're looking for more blue chip income stock ideas, then I'd recommend a look at 5 Shares To Retire On.
This exclusive Motley Fool wealth report contains details of five companies which the Fool's investment gurus believe could beat the market consistently over the long term.
If you'd like to know more, download this FREE, no-obligation report immediately.
To get your copy today, just click here now.
Roland Head 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.