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This Model Suggests Lloyds Banking Group PLC Could Deliver A 53.1% Annual Return

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Banks are traditionally seen as income stocks, but Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US) doesn’t currently pay dividends, thanks to the taxpayer-funded bailout it received during the financial crisis.

Lloyds is expected to get permission from its regulators to resume dividend payments in the next twelve months, during which time the government is expected to continue to sell its remaining 32% stake in the bank.

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The government’s next Lloyds share sale is expected to be open to private investors, as well as institutions. As a potential Lloyds buyer, I need to know what kind of return I can expect from Lloyds shares, before I can decide whether to invest.

Is Lloyds worth the risk?

Ideally, individual share purchases should offer a total return in excess of 8% – the long-term average total return from UK equities – to justify the extra risk and complexity of an actively-managed portfolio.

Lloyds lack of recent dividend history makes it harder to model the likely returns from this stock, but we do have some clues to work with.

Firstly, analysts’ consensus forecasts are suggesting Lloyds will pay a dividend of 2.3p next year, providing a 2014 prospective yield of 3.2%.

Secondly, Lloyds’ chief executive, António Horta-Osório, recently told investors he is aiming to pay out 70% of the bank’s earnings as dividends by 2015.

Finally, analysts expect Lloyds to report earnings per share of 5.2p this year, and 6.8p in 2014.

However, for Lloyds’ dividend to increase from 2.3p in 2014 to 70% of earnings – probably around 5p – in 2015, seems a bit optimistic to me. Instead, I’ve calculated a cautious estimate that assumes next year’s 2.3p forecast dividend will rise by around 50% in 2015, which would take it to about 3.5p.

Using these numbers, I’ve calculated the potential total return from Lloyds shares over the next few years, using a variation of the dividend discount model, which is widely used for this purpose:

Total return = (Prospective dividend ÷ current share price) + expected dividend growth rate

(2.3 ÷ 76) + 0.5 = 0.531 x 100 = 53.1%

My cautious model suggests that Lloyds shares could deliver a total return of 53% over the next few years — but if Lloyds’ CEO lives up to his promise and pays out 70% of earnings as dividends in 2015, the return could be far higher.

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 > Roland does not own shares in Lloyds Banking Group.

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