When it comes to valuation, there are so many ways methods to measurethe worthof any given company and some would argue its more of an art than a science.
Today, Im running Lloyds Banking Group plc (LSE: LLOY) shares throughBenjamin GrahamsRule of Thumb valuation technique and finding thatthey could offer prospective investors realvalue at currentprices.The techniquewas designed by the father of value investing to simplifythe more complex Discounted Cash Flow method.
Doing the math
First, certain assumptions are required in order to perform theanalysis, as the whole topic of stock valuation is forward-looking. Also understand that the final stock value will vary based on the assumption of scenarios.
Instead of trying to pinpoint one number, the science behind valuing stocks is to come up with a range of values tohelp you think about the downside as well as the upside.
The original formula from Security Analysis was:
V * = EPS x (8.5 + 2g)
Here V is the intrinsic value, EPS is the trailing 12-month EPS, 8.5 is the PE ratio of a stock with 0% growth and g isthe growth rate for the next 7-10 years.
Theformula was later revised as Graham included a required rate of return.
V * = EPS x (8.5 + 2g) x 4.4 / Y
What differs isthe number 4.4. Thats what Graham determined ashis minimum required rate of return. At the time (1962) when hewas publicising his works, the risk-free interest rate was 4.4%. To adjust for today, divide this number by the AAA corporate bond rate, represented by Y in the formula above.
Running the numbers
Imrunning the figuresthrough the Stockopedia valuation tool were I can adjust them with a view to being slightly conservative and letting the computers do the hard work.
First, I input the Earnings Per Share (EPS). While theres no specific guidance as to the best figure to use, I prefer the 2014 normalised EPS figure of 3.74p. Yes, there are other options, like forecast earnings, butthis risks double-counting growth and relies on analysts who arent always accurate.
Next, Iinput the medium term growth rate, not easy forLloyds given the impact of the financial crisis on earnings. So Im choosinga conservative 15%, significantly below expected growth for this year, but smooths things out over the medium term.
Third comes the growth multiplier. Again, Im being conservative foran extra safety layer and reducing itto 1.5 instead of the 2 in the original formula.
Finally, I input the yield on a 20-year AAA corporate bond. According to Yahoo Finance, this is currently 3.88%. Thefigure can be adjusted according to therisk profile.
And the result? Believe it or not, this gives an implied value of 131.48p some 80% higher than Fridays closing price. Yes, valuation may bemore of an art than a science, but Lloyds looks cheap on other metrics too. The forecast 12-month rolling P/E is under 10 times earnings and the shares are forecast to yield 5%. Andthe price to tangible book value is just 1.07, making it unlikely that youre currently paying over the odds.
Undervalued = opportunity
As you can see from the chart below, Lloyds shares have come off recent highs and underperformed the market of late perhaps itsa good time to take a position in a UK banking giant, that could be seriously undervalued.
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Dave Sullivan has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.