Should Long-Suffering Lloyds Banking Group PLC Shareholders Buy More Or Sell?

Lloyds Banking Group (LSE: LLOY) has been a frustrating investment over the last year. Should you keep the faith in the firm’s ability to return to growth, or is it time to bail out?

It’s probably fair to say that the headwinds facing the firm are stronger than they were last year. Much of Lloyds’ profit comes from its position as the UK’s largest mortgage lender, with a market share of about 20%. But tighter restrictions on buy-to-let lending announced on Tuesday seem likely to restrict growth in this area, as do unaffordable prices in many parts of the south east.

This restricted outlook is reflected in consensus forecasts for the bank’s 2016 earnings per share. Although forecasts have edged higher over the last month, current estimates for earnings of 7.7p per share are nearly 10% lower than one year ago.

Despite this, Lloyds’ shares still look cheap enough, with a 2016 forecast P/E of 8.8. The real problem is next year. Current forecasts suggest that Lloyds’ profits will be flat in 2017, as lending growth slows. If this happens, then the bank could soon find its ability to increase dividend payments is restricted.

In my view, this is why Lloyds shares trade on a low forecast P/E . The market is pricing in zero earnings growth, as the effects of government house-buying subsidies and cheap mortgages tail off.

Should we be worried?

Lloyds’ heavy dependence on mortgage and consumer lending is a risk. But banks are much stronger than they were in 2008. Lloyds passed the Bank of England stress tests before Christmas and its Common Equity Tier 1 ratio of 13% is well above the minimum required. Banks now operate under much tougher rules than in 2007/8. I think a major crash is unlikely.

What seems more likely to me is that Lloyds’ ability to grow earnings and increase its dividend may be weaker than expected.

Analysts hiked their dividend forecasts significantly following the bank’s results in February. Consensus forecasts for the 2016 dividend rose from 3.7p per share to 4.3p per share. At the current share price of 68p, that rise adds nearly 1% to Lloyds’ forecast yield.

I wonder whether City analysts have got slightly carried away by the bank’s generous payout for 2015. Lloyds’ forecast dividend yield has now risen to 6.3% for 2016 and to 7.4% for 2017. Next year’s payout ratio is expected to be 65% of earnings, which is relatively high.

Buy or sell?

The good news is that because Lloyds is already the UK’s largest mortgage lender and has a big share of the retail market, it doesn’t need to grow aggressively.

As long as the bank doesn’t run into any problems with bad mortgage debts, management can afford to pull back slightly and wait for lending conditions to improve again. In the meantime, Lloyds’ market-leading cost-to-income ratio of 49% should mean that it can afford to maintain generous dividends.

I wouldn’t sell shares in Lloyds today unless I wanted to lock in a long-term capital gain from the bank’s turnaround. In my view Lloyds is likely to remain a good income stock, even if dividend payouts are slightly lower than current forecasts suggest.

However, if you're looking for shares with the potential to deliver big gains, then you may want to look elsewhere.

A good option might be the company featured in A Top Income Share From The Motley Fool.

The company concerned is smaller than Lloyds, but offers an attractive yield and good growth potential.

The Motley Fool's experts believe this firm is likely to benefit from improving trading conditions. Their view is that profit margins could rise significantly.

If you'd like full details of this exciting opportunity, download our free, no-obligation report today. Just click here now.

Roland Head 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.