Would a Brexit recession send Lloyds Banking Group plc crashing to 42p?

Earlier this week Mark Carney, the Bank of England’s governor, caused a stir after he warned that the risks of Britain leaving the EU “could include a technical recession” as the uncertainty following the event may cause both growth and sterling to fall and unemployment to rise.

Whether or not the UK will slump into a recession following a ‘leave’ vote remains to be seen, but it’s clear that if the UK does tear itself away from the European block, there will be a certain amount of economic uncertainty in the weeks and months following. 

Uncertainty generally leads to a more cautious stance by both consumers and businesses, which will be bad news for Lloyds (LSE: LLOY)

Housing boom 

As the UK’s largest mortgage lender and one of the country’s largest retail banks, Lloyds’ growth is highly correlated to the UK’s economic performance. 

And over the past five years, Lloyds has received a huge boost from mortgage lending as the UK’s housing market has taken off and house prices have surged to record levels. This growth has helped Lloyds achieve one of the best returns on equity and capital ratios in the European banking industry.

For the three months ended 31 March 2016, Lloyds’ net interest margin, the difference between interest income generated and the amount of interest paid out to depositors, ticked higher by 10 bps to 2.75% from 2.64% as reported last quarter. The bank’s cost-to-income ratio fell to 47.4%, down from 47.7% a year ago, return on equity came in at to 13.8% and Lloyds’ capital reserves expanded to 13%, from 12.8% at the end of last year.

What’s more, Even if these metrics don’t improve over the next 12 months, Lloyds’ earnings will still get a boost from the bank’s decision to buy back so-called enhanced capital notes, which will give the lender a £900m cash injection over the next four-and-a-half years.

Following the bank’s sector-leading performance, investors have been pushing Lloyds’ valuation higher, and the bank now trades at a premium to the wider European banking sector. 

Specifically, Lloyds is currently trading at a price-to-tangible-book value of 1.3 compared to the broader European banking sector, which is trading at a price-to-tangible-book value of below 0.8. Lloyds’ UK peer Barclays trades at a price-to-tangible-book ratio of 0.6. 

If the UK’s lending and economic growth stalled, it’s likely Lloyds’ valuation could fall back into line with its European peers as investors reconsider the group’s growth prospects. At a valuation of 0.8 times tangible book, Lloyds shares would be worth around 42p, more than 30% below current levels. If the bank’s valuation falls to a similar level as that of Barclays, the shares would be worth 31.2p, 52% below current levels. 

The bottom line 

So, there’s a real risk that if the UK leaves Europe shares in Lloyds could fall by as much as 52%, which would be a disastrous result for shareholders. 

Still, City analysts believe that Lloyds has the capacity to pay 10p per share to investors via dividends, excluding any special payouts during the next two years. At 31.2p this cash return would translate into a dividend yield of 32%. Of course, Lloyds’ management may decide to save cash if the bank’s growth slows.  

To help you evaluate Lloyds for yourself, our top analysts have put together this report, that guides you through the 10 essential steps you need to take to become a stock market millionaire. 

The report explains how spending just 20 minutes a month could help you create a portfolio that could bring you closer to financial freedom for life.

Click here to check out the report - it's completely free and comes with no further obligation. 

Rupert Hargreaves 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.