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Lloyds Banking Group (LSE: LLOY) shares are on my buy list. There are three reasons I add this. FTSE 100 Bank to my portfolio today.
Increase in interest rates
Big banks have worked hard to rid themselves of the bad habits that got them into trouble in 2008. They have made good progress, but one key ingredient has been missing from their recovery – higher interest rates.
Near-zero interest rates have made it difficult for banks to offer competitive mortgage rates without reducing their profit margins. But all that is beginning to change.
With inflation in the UK at 10%, prices are rising. The Bank of England’s base rate has risen to 1.75% from 0.25% so far this year. Most experts expect another increase in September.
The rising bank rate is allowing Lloyds to increase the interest rates it charges on loans and borrowings. That’s helping Lloyd’s make more profit on loans.
Improved profitability should lead to stronger cash flow, supporting profit growth.
A 13% shareholder return?
One simple valuation technique used by urban number crunchers is to use the expected dividend growth rate to predict stock price returns. The idea behind this is that if the dividend yield remains the same, the shares will increase by the amount of the dividend paid each year.
Obviously, things don’t always work out this way. But I’ve found this to be a useful way to spot potentially undervalued stocks.
Looking at Lloyds, the stock’s forecast 2022 dividend yield is 5.4%. In the year By 2023, the dividend is expected to increase by 8%. Adding these two numbers gives me a total return (dividend yield and stock price return) of just over 13 percent.
This is well ahead of the long-term average total return for UK equities of around 7% per annum. That’s one reason Lloyd’s shares may be cheap at current levels.
Buy Lloyd’s shares at a discount?
Another reason why Lloyds looks cheap is that the bank’s shares are still trading 56p below their intrinsic book value.
A discount to book value is a traditional value indicator. In recent years this decline has been explained by weak profitability. But with interest rates on the rise, I don’t think this applies anymore.
In my view, Lloyd’s shares could trade significantly below their book value in the future. If the bank’s profitability is stable enough, they may trade above book value.
Right time to buy?
Before I buy a share, I always ask myself what could go wrong. With Lloyd’s, the risks are clear enough.
There is a real chance that the UK could go into recession later this year. This would lead to a sharp increase in banks’ losses due to bad debt and a slowdown in new mortgage lending.
In July, Lloyd said he had yet to see any signs of trouble. But with the coming of winter and the possible energy crisis, problems may arise in the future.
I am not blind to the dangers. But I think Lloyd’s shares are priced to reflect potential problems. In my view, the shares offer good value for the long term. I would be happy to buy at current levels.