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Is this rising star a better banking buy than Lloyds Banking Group plc?

Lloyds (LSE: LLOY) is undoubtedly the UK’s best large bank, but the group is facing increasing competition from smaller challenger banks that are taking market share and shaking up the banking market by introducing new ways of doing business. 

Provident Financial (LSE: PFG) isn’t a challenger, but it is one of the companies shaking up the UK lending market, which has traditionally be dominated by large banks. However, thanks to the tidal wave of regulation that has been introduced since the financial crisis, banks are pulling back from this area, and lenders like Provident are stepping in to fill the gap. 

Experienced growth 

Provident has been around in one form or another since 1890, so the company and management knows how to operate through both the good times and the bad. Regulations aimed at big banks have helped accelerate the company’s growth since the crisis with earnings per share next year on track to have expanded by 100% since 2012 — the sort of growth large banks would kill for. 

The company has been able to achieve this growth by targeting the low credit quality end of the market. Here, margins are still fat, and while regulations are stringent, the potential profit on offer makes dealing with the additional regulation worthwhile. For example, for full-year 2016, Provident reported a return on assets of 15.3%, down from 16.1% in 2015. For the same period, Lloyds reported a return on risk-weighted assets of 3.6%. 

Conglomerate business

Provident is a collection of businesses, a model which allows the firm to target several areas of the market while at the same time keeping risk contained. The group owns Moneybarn, a bad credit car finance company, as well as Satsuma, a payday lender. Both of these businesses produce a 20%-plus return on equity, but they’re not without their risks. As a holding company, Provident is to some extent insulated from these risks. 

That being said, unlike Lloyds, Provident is not regulated like a bank, so investors are exposed to a higher level of risk. This might be enough to put some investors off. If the business hasn’t got its risk calculations right, bad debts could quickly overwhelm it if the UK economy hit the rocks. By comparison, Lloyds is subject to annual stress tests by both the European Central Bank and Bank of England. In the last set of stress tests, which simulated a 2008 style crash, its capital position was estimated to fall from 13% to 10%, still a comfortable level. 

A better buy? 

So is Provident a better buy than Lloyds? Well, the lender’s growth is certainly attractive and so is the dividend yield which currently stands at 4.9%. Nonetheless, when it comes to valuation Provident lags Lloyds.

Shares in Provident are currently trading at a forward P/E of 15.9 compared to Lloyds’ 9.8. Shares in Lloyds also support a dividend yield of 5.4%. Looking at these figures, despite Provident’s growth a position in the UK lending market, I’d say Lloyds remains the better buy. 

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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.