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He FTSE 100 has risen almost 7% so far this year as demand for top-of-the-line bargains has increased. Cheap Lloyds Banking Group (LSE:LLOY) shares are up an even more impressive 17%, reflecting the improving mood in the UK economic and political landscape.
However, today, shares of this major bank still look cheap. They trade on a price-to-earnings (P/E) ratio of 8.5 times, well below Footsie's average of over 15 times.
Lloyds shares also offer excellent value on paper from a dividend perspective. Its dividend yield of 5.8% is well above the 3.6% average for British large caps.
To make matters worse, Footsie Bank is also undervalued relative to the value of its assets. As the chart shows, its price-to-book (P/B) ratio is comfortably below the 1 value watermark.
On the positive side
Lloyds' share price has risen mainly due to improving hopes for the UK economy. With growth picking up and interest rates falling, investors are more optimistic about the company's earnings outlook and deterioration forecasts.
The IMF's decision to upgrade UK GDP forecasts last week further boosted market sentiment. Growth is now forecast at 1.1% by 2024, significantly up from 0.4% previously.
Lloyds shares have also risen, amid signs of a steady recovery in the property market. This is especially important for this bank given its status as the largest provider of mortgage loans in the country.
Possible car accident
However, Lloyds also faces significant risks in the near term and beyond. In fact, I fear they could prompt a strong rerating given the recent jump in the bank's share price.
A large and growing threat is the possibility of substantial financial penalties if you are found guilty of overcharging on auto loans. Things have become more precarious after the Court of Appeal ruled on Friday that car dealer commissions should be approved by borrowers before they are enforced.
Lloyds' share price has fallen sharply following the news. It has set aside £450m to cover claims but could face a substantially larger bill, running into billions.
He said today that last Friday's ruling “sets a higher standard for disclosure and consent to the existence, nature and amount of any commission paid than had been understood to be required or applied across the auto finance industry prior to the decision..”
Lloyds added that it is “Assess the potential impact of decisions, as well as any wider implications..” This uncomfortable reminder of the costly PPI scandal after 2008 could have similar adverse consequences for Black Horse Bank.
too risky
While significant, this is not the only big risk to Lloyds and its share price at the moment.
Margins are being hit as the Bank of England cuts rates and competition intensifies in UK banking. These fell 20 basis points to 2.94% in the third quarter, and could fall much further.
Please also remember that the UK's economic recovery remains on fragile ground. A host of factors, from this week's budget fallout to the US presidential election in November, could hurt growth and, with it, the fortunes of cyclical banks.
I believe the dangers of owning Lloyds shares outweigh the potential rewards, even at the current price.
