Why Lloyds Banking Group plc could have further to go

A lot of investors may have given up hope on shares in Lloyds Banking Group (LSE: LLOY). After all, the bank’s shares were among the worst hit by the Brexit vote, and even the government is selling its stake at a loss. Yesterday, Lloyds said in a statement the government had reduced its stake in the bank by around 1 percentage point to below 7% — this implies the government sold its latest 1% stake at a discount of around 18% from its 73.6p break-even price.

Despite this, I remain confident about the bank’s future prospects. Lloyds has made steady progress in improving its profitability and, most importantly, I think valuations are currently too cheap to ignore.

Fundamentals remain positive

Although underlying profits in the first nine months of 2016 fell by 4% to £6.1bn, it wasn’t too disappointing because it was against a strong comparator from last year. In addition, Lloyds is still generating a very respectable underlying return on equity of 13.6%. That’s significantly above that of other big UK banks, and is all the more impressive given today’s tougher regulatory environment and stricter capital requirements.

With net interest margins at 2.72% and a cost-to-income of 47.7%, Lloyds’ financial metrics are market-leading and they’re continuing to improve. The bank’s strong underlying performance is the direct result of its simple business model: to focus almost entirely on retail and commercial banking in the UK, and to leverage those synergies and benefits of scale to strengthen its market-leading position.

Credit quality remains strong, and so far, there hasn’t been a significant increase in loan losses from the bank’s portfolios. And even if the economy slows, I don’t expect loan losses would get that bad. That’s because the bank’s lending standards have fundamentally changed following the financial crisis and it doesn’t appear that bubbles have formed in the domestic credit markets.

Downside risks

That said, investing in Lloyds isn’t without its risks. The bank does face some significant political and regulatory risks that could cause problems in the future. Although they seem largely forgotten, the legacy misconduct troubles hampering Lloyds’ profitability are still ongoing. In particular, PPI claims appear to be on the rise, meaning banks could face higher PPI provisions as the Financial Conduct Authority (FCA) delays its decision to set a deadline for claims.

There are also concerns that Lloyds may be facing intensifying competition. On Monday, investment bank Goldman Sachs said Lloyds is currently charging 50 basis points more than its peers in the mortgage market, which could see the bank forced to cut rates or else face the risk of losing its customers.

Dividend potential

Nevertheless, Lloyds has a robust balance sheet and generates plenty of cash. This means it should have sufficient capacity to boost shareholder payouts in the future. The bank paid a special dividend of 0.5p a share this year, which brought total dividends for the 2015 financial year to 2.75p a share.

Looking forward, City analysts expect the bank to pay 3.1p a share for this financial year, with a further increase of 0.55p a share for 2017. Based on these estimates, shares in Lloyds have an indicative forward dividend yield of 5.1% for 2016, and 6*% for 2017. On earnings, valuations are tempting too — Lloyds is valued at 8.5 times its forecast earnings this year, and 9.3 times its 2017 expected earnings.

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Jack Tang has a position in 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.