This P/E Suggests Lloyds Banking Is a Hold

LONDON -- The FTSE 100 has risen by 25% over the last year, and many top shares are beginning to look quite expensive.

I'm on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I'm using a special version of the price to earnings ratio called the PE10, which is one of my favorite tools for value investing.

The PE10 compares the current share price with average earnings per share for the last ten years. This smoothes out any short-term volatility and lets you see whether a company looks cheap compared to its long-term earnings.

Today, I'm going to take a look at the PE10 for Lloyds Banking Group (LLOY 0.41%) (LYG 0.38%).

Have investors gotten ahead of themselves?
Since the U.K. government took a 39% stake in Lloyds in 2008, the bank's share price has fluctuated wildly, but it has risen by 143% over the last year, taking it above the 61 pence threshold that the government claims is its break-even point.

Lloyds' management is confident that the bank will make a statutory profit this year, and its shares now trade around 12% above their tangible net asset value, unlike those of Barclaysand Royal Bank of Scotland, which continue to trade at a discount to book value.

So does this mean that Lloyds' recovery is complete, or have investors got ahead of themselves? Let's take a look at Lloyds' current price-to-earnings ratio, and its PE10:

I was unable to calculate a trailing P/E for Lloyds, as it made a loss last year, so I've substituted this year's forecast P/E, based on City analysts' forecasts.

The big difference between Lloyds forward P/E of 13.2 and its PE10 of 2.4 shows the scale of the challenge that remains ahead of the bank. Can its earnings ever return to the 40p-plus earnings per share levels seen before the financial crisis?

Hold Lloyds
I think Lloyds is a hold at the moment.

Investors who bought the bank's shares when they hit all-time lows in 2012 are sitting on a good profit, but Lloyds' forward P/E of 13 suggests to me that a lot of progress has already been priced into the shares, and that further gains in the near term are unlikely.

Given this, I think there are currently better opportunities elsewhere in the banking sector.

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