Shares in Lloyds Banking Group (LSE:LLOY) are down 10% over the last month. As a result, the stock now trades at a price well below 50p per share.
The stock has found itself caught up in the fallout from the liquidity issues in the US banking sector. But does the recent fall in the share price mean it’s cheap?
Valuing bank shares
A basic way of valuing bank stocks involves dividing the return on equity (RoE) by the price-to-book (P/B) ratio. The rationale for this is straightforward.
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RoE indicates how efficient a bank is at making money using its equity capital, and the P/B ratio measures the cost of that equity to an investor. The higher the number, the higher the return.
According to its last earnings report, Lloyds managed a return on tangible equity of 13.5% in 2022. That’s a decent return, but the stock being cheap depends on the cost of that equity.
That earnings report showed Lloyds has around 52p in tangible equity per share. At today’s share price, that means it’s trading at a P/B multiple of 0.9.
Dividing 13.5 by 0.9 gives a return of 15%, which is terrific. Banking is a highly cyclical industry though, so it makes sense to wonder whether this is going to be sustainable.
Recession
Looking forward, it’s clear to me that 2022 was an unusually good year for Lloyds. The company’s margins were boosted by rising interest rates, which I don’t think is sustainable.
If interest rates continue to rise, there’s an increased risk of a recession, despite the Office for Budget Responsibility predicting we’ll avoid one. Even without a technical recession, a sluggish economy could be a headwind for the bank as borrowers start to default on their loans.
I don’t think this is an existential threat to Lloyds — the company has significant reserves to guard against this. But it’s likely to mean profits come in lower.
The company’s guidance is for a 13% return on tangible equity going forward. That’s a little lower than 2022 levels, but it would still be a great return for an investor.
Liquidity
The macroeconomic environment looks to me like the biggest risk for Lloyds shares at the moment. But the stock has been falling lately because of the liquidity crisis around US banks.
I think the risk here is pretty minimal though. There are two important differences between Lloyds and the failed US institutions.
First, the UK bank has much more exposure to retail banking and a far lower concentration of tech start-ups among its customers. This reduces the likelihood of mass withdrawals.
Second, the worst-affected banks in the US have been the smaller institutions. Thus far, JPMorgan Chase and Wells Fargo appear to have been largely unaffected.
As one of the biggest banks in the UK, I think that Lloyds is likely to be fine in a similar liquidity crisis in the UK. I see it as the kind of bank that customers would be running towards, not away from.
Undervalued?
Overall, I feel that Lloyds shares are undervalued at the moment. The risk of a recession is priced in and the share price fall from the liquidity crisis in the US offers an extra margin of safety.
