Shares in Lloyds Banking Group (LSE:LLOY) have served investors well over the past year. The share price is up around 26% over the last 12 months.
In general, stocks tend to trade at bargain prices when the market is looking elsewhere. But in the case of Lloyds, I think its low price is undeserved.
Income streams
Lloyds has four main income streams – net interest income, fees and commissions, trading, and insurance. The largest of these is net interest income.
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This comes from taking in deposits (and paying interest on them) and making loans (and receiving interest on them). Mortgages make up the majority of the bank’s loans.
Rising interest rates meant that Lloyds did very well in 2022. Its net interest margin – the gap between the interest it pays on deposits and the interest it receives on loans – widened.
Even with this likely to subside in 2023, I think this looks like a stock to buy. The business has a strong competitive position and trades at an attractive price.
Business strength
Lloyds has proven itself to be resilient in a crowded industry. The bank has maintained a strong market position despite competition from challengers like Paragon and Monzo.
The ability to attract deposits is important for banks. Access to a low-cost deposit base is one of the things that Warren Buffett cites as an advantage of Bank of America.
I think that something similar is true of Lloyds. The bank has the highest share of retail deposits in the UK and is one of the biggest current account providers.
This provides the business with a low-cost source of funding that it can use to finance its loans. And it’s an advantage that other banks are unable to replicate as easily.
Valuation
There’s a common metric for valuing bank stocks. It involves taking the company’s return on equity and dividing it by the cost of equity to an investor – the price-to-book (P/B) ratio.
By this metric, Lloyds shares look like a bargain. With a return on equity of around 11% and a P/B ratio of 0.74, the expected return comes out at around 15%.
That’s a very solid return. For comparison, Bank of America’s return on equity is 10% and it trades at a P/B ratio of 1.12, giving it a return of 9%.
On top of this, there are other avenues for growth available. Lloyds is attempting to grow its credit card base, to help increase its revenue from fees.
A stock to buy
With banking, there’s always a danger of loan defaults. Mortgages make up around 66% of the loans Lloyds has on its balance sheet, so this is something it would be unwise to ignore.
I think that the risk of serious damage to the business from loan defaults is reasonably low, though. The company has significant reserves set aside to cover this possibility.
It looks to me like a strong business trading at a decent price. I’m looking to add the stock to my portfolio in the near future.
