Since the EU referendum, Lloyds (LSE: LLOY) has slumped by 28%. Clearly, this is hugely disappointing for its investors and it almost doesn't need to be said that the bank's outlook is highly uncertain. A slowdown in the UK economy now seems likely and while a recession may not occur, the UK could be in for an extended period of difficulty as it slowly negotiates its exit from the EU.
This may lead investors to determine that Lloyds is a stock to avoid. After all, it's heavily exposed to the UK through its acquisition of HBOS during the credit crunch. If the UK housing market falls and consumer and business confidence comes under pressure (all of which seem likely), Lloyds could be nursing downgrades to its profit forecast.
However, these problems appear to be priced-in to Lloyds' current valuation. It trades on a price-to-earnings (P/E) ratio of just 7. That's just over half the P/E ratio of the FTSE 100 and indicates that Lloyds offers a very wide margin of safety at the present time. This indicates that if the outlook for the bank was to deteriorate, the market already appears to be pricing-in such an eventuality and so Lloyds' shares may not be hit exceptionally hard. Similarly, if Lloyds' financial performance is better than expected then its shares could be substantially uprated.
Clearly, Lloyds experienced a challenging period during the credit crunch and became lossmaking, with a government bailout being required. Since then, Lloyds' management team has performed well to make it among the most efficient of the UK-focused banks and it now has a strong balance sheet that has been substantially de-risked.
Furthermore, the wider UK banking system is in a much stronger position than it was prior to the credit crunch. This means that even if a recession does occur, it's unlikely that it will lead to a banking crisis. As such, Lloyds' low valuation could be seen as difficult to justify given its bright long-term future.
In addition, Lloyds is expected to become a very enticing income play. It's due to yield 7.3% in the current financial year. Certainly, there's scope for a cut in dividends if the UK's economic outlook deteriorates, but with shareholder payouts being covered almost twice by profit, Lloyds may not need to slash dividends in such a scenario. Rather, a modest cut may be sufficient.
With interest rates likely to fall from their historic low of 0.5%, Lloyds could become an enticing income play. Therefore, investor demand for higher-yielding shares could push its valuation higher.
Based on its risk/reward ratio, Lloyds makes sense as an investment at the present time. Its future won't be easy or straightforward, but with a wide margin of safety as indicated by its low P/E ratio, the rewards could be sizeable for long-term investors.
Peter Stephens owns shares of Lloyds Banking Group. 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.