I really cant figure out why the entire FTSE 100 banking sector is so lowly valued right now.
Sure, I can see real risks forHSBC Holdings and Standard Chartered with their massive exposure to Asia and no idea what toxic debt they might be left with if China really implodes. Around 80% of their turnover comes from the Asian region and I can understand why their shares are on forecast P/E ratios of between eight and nine for this year.
And it makes sense seeing Royal Bank of Scotland out of favour. Its been so much slower than its rivals to turn its back on the crisis and it might only just manage a tiny dividend this year.
Theyre not all bad
But when I see Lloyds Banking Group (LSE: LLOY), on a forecast P/E of only 7.6 for the current year, with its dividend already expected to be back to a 5.1% yield, I shake my head in bewilderment. And Im stymied when I try to understand a 2016 P/E as low as 6.2 for Barclays (LSE: BARC) while it has strong earnings growth on the cards. Dividends arent as good as at Lloyds yet, but the 3.6% yield forecast for this year still beats the FTSE average, and with mooted 2016 dividend cover at more than three times I wouldnt be surprised to see 5% in 2017.
The lastest share prices, of 61p for Lloyds and 161p for Barclays, put the two banks on lower valuations than HSBC and Standard Chartered, yet neither has anything like the same Asian exposure.
And Lloyds is on a lower valuation than fellow bailed-out struggler RBS. Although the 0.4% dividend yield expected from RBS is negligible compared to Lloyds 5.1%, RBS shares are on a higher P/E at just under 11. Are RBS shares really worth 50% more than Lloyds right now? I really dont see it.
But the big question is, whats a fair value for a bank?
Whats a fair price?
I think its fair to rate our big banks at a little below the long-term FTSE average of around 14 in the short term, but not a lot lower. And with the sector in a far fitter financial state than its been for decades, that average of 14 doesnt seem unreasonable in the medium term.
For Lloyds, that would suggest a share price rise of 84% to 112p. Add a few years of compounding 5% dividends through reinvestment and wed be close to that double.
Over at Barclays, a P/E of 14 alone would need the share price to more than double to 363p by the end of 2016. With possibly greater risk of further financial penalties for various past actions, and a little uncertainty aroundthe direction of Barclays structural reform, I can see a slightly lower P/E for a little while. But a multiple of 12 would still see a near-doubling, and dividends would soon make up the rest.
A great opportunity
Are my guesses anywhere near the mark? Well, Im not trying to make hard and fast predictions, but I do think that Lloyds and Barclays are the most attractive of our banks right now and are seriously undervalued. And theyre being held back by the sector in general, as other banks are facing significantly more serious risks.
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Alan Oscroft owns shares in Lloyds Banking Group. The Motley Fool UK has recommended Barclays and HSBC Holdings. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.