Do Lloyds Banking Group PLC’s Risks Outweigh Its Potential Rewards?

With any investment, the potential rewards on offer must outweigh its risks in order for it to be worthwile. If not, then it could mean the chances of making a profit are reduced and as such, it may be prudent to look elsewhere. For many investors, this may seem to be the case with Lloyds (LSE: LLOY), with the part-nationalised bank’s share price having fallen by 8% in the last six months.

Of concern for investors in Lloyds is its near-term outlook. It’s forecast to post a fall in earnings of 10% in the current year and this could cause investor sentiment to weaken in the near term. Furthermore, Lloyds itself warned this week of the uncertainty which a vote for Britain to leave the EU would create in the short term. This could also have a negative impact on the bank’s share price and is a significant risk to its future performance.

In addition, there’s the issue of privatisation. The government recently put on hold plans to sell its stake in Lloyds and while the bank is now profitable and returning to full health, the issue of a government share sale is hanging over it. This is unlikely to be aiding demand for Lloyds’ shares, since potential purchasers may instead be waiting for the government share sale since it could offer a discount and bonus shares. As such, demand may be relatively low over the short-to-medium term, thereby hurting its share price even further.

Worth buying

Despite these risks, Lloyds could still be worth buying due to its potential rewards. Although the current year is set to be a disappointment, Lloyds is forecast to return to growth next year with a rise in earnings of 2%. And with the bank having a sound strategy and having become more efficient in recent years, it seems to be well-placed to deliver much higher levels of growth in the long run.

Furthermore, Lloyds offers a wide margin of safety so that even though there are risks, it could still merit investment in spite of them. For example, Lloyds has a price-to-earnings (P/E) ratio of just 8.8 and even though its short-term performance is likely to disappoint, it’s difficult to justify such a low valuation for such a high quality business. As such, Lloyds’ share price could rise significantly if investor sentiment improves.

One catalyst to affect this could be rising dividends. Lloyds yields 6.4% at the present time and with dividends per share expected to increase by 18% in 2017, income-seeking investors could bid up the bank’s share price as they seek what is a superb yield. And with interest rate rises likely to be infrequent and small in the coming years, such a high yield could prove to be irresistible for many investors.

So, while Lloyds isn’t without risk, its potential rewards appear to be sufficient to warrant purchase at the present time and its wide margin of safety should give new investors in the company confidence in its long-term investment prospects.

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Peter Stephens owns shares of Lloyds Banking Group. 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.