Banks like Lloyds Banking Group (LSE:LLOY) can be excellent shares to buy for a solid passive income.
The interest from their lending activities provides a consistent and significant flow of cash that they can then distribute to their shareholders. This can be done through a large and growing dividend as well as via share buybacks.
The dividend on Lloyds shares has risen every year since the depths of the Covid-19 crisis. And City analysts expect it to continue growing through to 2026, at least.
As a consequence, the market-beating dividend yields that Lloyds is famous for get steadily higher over the period. This is shown in the table below.
| Year | Dividend per share | Dividend growth | Dividend yield |
|---|---|---|---|
| 2024 | 3.3p | 20% | 5.6% |
| 2025 | 3.48p | 6% | 5.9% |
| 2026 | 4.04p | 16% | 6.9% |
But income investors need to consider how realistic current dividend projections are before buying in. They must also think about weighing up the prospect of more large cash rewards with the potential of a stagnating (or even falling) Lloyds share price.
Here’s my take on the FTSE 100 bank.
In great shape
The first part of my assessment’s pretty encouraging. I believe Lloyds is in great shape to pay the huge dividends analysts are expecting.
For the next three years, dividends at the Black Horse Bank are covered between 2 times and 2.2 times by expected earnings.
Both figures sit around the accepted safety benchmark of 2 times and above. This is important given that the UK economic outlook remains highly uncertain which, in turn, poses a threat to banking sector profits.
Investors can also take comfort from the healthy conditions of Lloyds’ balance sheet. As of June, its common equity tier 1 (CET1) capital ratio was a robust 13.7%. It means the bank could continue to pay large dividends even if earnings disappoint.
Big risks
The dividend picture’s pretty exciting at Lloyds, it’s fair to say. But does this necessarily make the bank a top stock to buy? I’m not convinced.
When investing, I’m looking for companies that can pay a passive income and deliver healthy capital appreciation over time. And I’m not certain the bank meets my criteria.
Lloyds’ share price has leapt more than 40% over the past year. But it remains almost a quarter cheaper than it was 10 years ago.
And I believe it could turn lower again soon as conditions become more difficult.
Firstly, the boost that higher interest rates have provided to margins are already unwinding. Lloyds’ net interest margin (NIM) sank 24 basis points in the first half, to 2.94%. And things will get even tougher if (as expected) the Bank of England steadily cuts interest rates over the next year.
Its margins are also coming under attack as challenger banks ramp up their operations. High street banks are having to increasingly slash loan costs or raise savings rates to stop losing customers to the likes of Revolut. And, so far, this is only having a limited benefit.
Cheap for a reason
The shares are currently really cheap. As well as having those large dividend yields, the bank trades on a price-to-earnings (P/E) ratio of 9 times.
However, in my opinion, this low valuation fairly reflects the risks the bank poses to investors. I’d much rather buy other dividend shares today.
This post was originally published on Motley Fool
