Lloyds Banking Group's (LSE: LLOY) earnings outlook has dimmed over the past year, but here's why investors shouldn't overlook the bank's dividend potential.
Higher yield than its peers
The first thing to notice is that Lloyds has a very attractive dividend yield. Lloyds' shares currently yield 4.4%, which is meaningfully above the FTSE 100's average yield of 3.6%. And the superior yield is even clearer in comparison to its bank peers, with the average yield for the sector being just 3.1%.
Although a higher yield may be cause for concern if the dividend is at risk of being cut, this doesn't seem to be the case here. Lloyds' financial performance has continued to improve and the stock's underlying dividend payout ratio of less than 50% seems reasonable.
Strong capital position
What's more, the bank has a strong capital position. Its latest published common equity tier 1 (CET1) ratio of 13.4% puts the bank among the highest among the UK's big four. Although it's clear that Lloyds is heavily exposed to the UK economy at a time of rising inflation and growing economic uncertainty, Lloyds' balance sheet demonstrated its resilience in the Bank of England's latest stress tests.
"Despite the more severe stress on the UK economy, the group comfortably exceeds the higher capital and leverage thresholds set out for the purpose of the stress test... The CET1 ratio low point under stress has improved since the 2015 exercise despite the more severe UK stress, reflecting the successful de-risking undertaken by the group," Lloyds stated.
Clearly, as a domestically-focused bank, Lloyds is highly dependent on the UK economy. Banking is a very cyclical sector, meaning earnings can sometimes be volatile. Certainly, Brexit and rising inflation present short-term risks. However, the bank's fundamentals are relatively strong. In addition to Lloyds' strong balance sheet, its leading market position in the UK gives it competitive advantages.
Firstly, its leading presence means it benefits from significant economies of scale -- its cost-to-income ratio is just 47.7%, the lowest of the big four UK banking groups. Lloyds' financial metrics are also market-leading, with net interest margins of 2.72% and an asset quality ratio of 14 basis points. With such strong fundamentals, this bodes well for Lloyds' bottom line outlook and puts it in a strong position to deliver steady dividend growth in future years.
Dividend track record
Lloyds doesn't have a perfect dividend track record, as it was forced to axe its dividend completely in the aftermath of the financial crisis of 2007/08. It only started to resume dividend payments two years ago, but unlike many other big UK banks, Lloyds has managed a successful turnaround in its underlying profitability.
City analysts expect it to return to deliver an underlying return on equity of above 12% in the coming years, with underlying earnings per share of 7.2p and dividends of 2.85p forecast for the 2016 financial year. Beyond next year, there's scope for additional dividend rises as Lloyds' recent MBNA acquisition is expected to improve its earnings outlook.
Jack Tang has a position in Lloyds Banking Group plc. 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.