Would a Brexit send Lloyds Banking Group plc's shares crashing to 40p?
On Thursday, it will be exactly two weeks until the EU referendum, which is set to take place on 23 June and the debate is really heating up ahead of the vote.
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The outcome of the referendum will have a greater impact on the majority of investors than the rest of the general population. If the 'vote leave' camp wins, it's clear that there will be a period of uncertainty after the referendum. When the dust has settled, it will take some time for lawmakers to come up with a comprehensive breakaway plan.
And it's during this period of uncertainty that most damage will be done to investors' portfolios and the UK economy. Indeed, if there's one thing the market and investors around the world can't stand its uncertainty and it's unlikely it will be any different this time around.
Extremely exposed
Lloyds (LON: LLOY) is extremely exposed to the UK economy as the bank is the UK's largest mortgage lender and has limited international operations after selling off non-core international divisions following the financial crisis. So, if house prices weaken following the referendum, Lloyds' earnings will take a hit as the demand for mortgages slows. What's more, Mark Carney, the governor the Bank of England, has hinted that if the UK's economy falls into a recession following a Brexit, the central bank could decide to push interest rates into negative territory, piling further pressure on Lloyds' ability to make money in a hostile economic environment.
That being said, it's almost impossible to try and predict exactly which direction Lloyds' shares will move after the referendum, but if uncertainty prevails, investors will seek solace in cash, which generally means selling shares across the board.
An uncertain environment
In an uncertain environment, Lloyds' shares are likely to suffer more than most. The bank currently trades at a premium to the wider European banking sector, a premium that could quickly evaporate if investors suddenly all rush for the exit.
Specifically, Lloyds is currently trading at a price-to-tangible-book value of 1.4 compared to the broader European banking sector, which is trading at a price-to-tangible-book value of below 0.8. Lloyds' UK peer Barclays trades at a price-to-tangible-book ratio of 0.6. Lloyds has been able to attract this premium valuation thanks to the bank's sector-leading return on equity of 13.8% as reported for the first quarter of 2016. However, in the event of a Brexit-induced recession, it's likely this return on equity will fall and Lloyds' valuation could fall back into line with its European peers as investors reconsider the group's growth prospects. At a valuation of 0.8 times tangible book, Lloyds shares would be worth around 42p, more than 41% below current levels. If the bank's valuation falls to a similar level as that of Barclays, the shares would be worth 31.2p, 56% below current levels.
The bottom line
So overall, there's a very real risk that Lloyds's shares could fall to 42p or 31p if the UK decides to leave the EU.
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Rupert Hargreaves 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.
