Up 38% in a year, here’s why some still think Barclays shares are dead cheap

Barclays (LSE:BARC) is one of the best-performing banking shares over the past year. Up 38%, it has vastly outstripped the broader FTSE 100. The argument is now whether Barclays shares are overvalued (and therefore should be avoided), or if there’s still room for the stock to appreciate. Here’s how I think the land lies.

The case for being cheap

The main reason cited by supporters is that Barclays continues to trade at a relatively low price-to-earnings (P/E) ratio. It stands at 10.23, which is pretty much bang on the fair value mark I use. However, when compared with the FTSE 100 average ratio at 16.2, it’s clearly cheaper than the benchmark.

Put another way, the profitability of the bank has significantly increased over recent years, but the share price hasn’t kept pace with this move higher. As a result, the P/E ratio is still relatively low. So even if the earnings per share doesn’t increase this year, the stock can still easily move higher before being judged overvalued on this metric.

Another factor supporting value is capital returns. Barclays has been focusing recently on a combination of dividends and share buybacks. In the latest results, the CEO said “our capital position remains robust with a 14.1% common equity tier 1 (CET1) ratio and we are announcing a £500m buyback today”.

Typically, companies look to make use of excess funds to buy back stock when management thinks the price is attractive. Even though I’m careful not to read into it too much, Barclays wouldn’t look to buy back a lot of stock if it thought the current share price overvalued the business.

Caution still needed

However, there is another side to the argument. The reason Barclays could be seen as cheap may be because investors continue to see genuine risks. Even as a global bank, Barclays is exposed to the fate of the UK economy, given its exposure to UK businesses and retail clients. A slowdown in the UK economy (which is already fragile) could lead to higher loan defaults, particularly in unsecured lending and credit cards.

The investment banking division also remains a source of debate. While it can generate significant profits during favourable market conditions, earnings tend to be volatile. Last quarter it generated over £4bn of income for the first time, as IPOs and M&A activity picked up. This is great, but such activity can fluctuate dramatically, which is one reason some investors might still be staying away.

My overall view

The risks around Barclays are valid, but I do believe it has the potential to move higher over the course of this year. Yet the scale of any such move is what doesn’t really get me excited. Even though I don’t see it falling, I struggle to see explosive growth and think there are better options for investors looking for capital appreciation.

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Jon Smith has no positions in the shares mentioned.