One of the attractions of holding banking shares is the potential income they can provide. While large banks are not typically fast-growing businesses in developed markets, they are often able to make big profits. In fact, the dividend at Lloyds (LSE: LLOY) is one reason I have been holding shares in the UK bank. But how reliable is the Lloyds dividend?
Business health and dividends
Ultimately, a company needs to be profitable to pay dividends year after year. The payments themselves may be made from free cash flow or reserves, so a year or two of negative earnings might not affect them. But a business that is consistently unprofitable will not be able to sustain dividends forever.
I think Lloyds has a robust business that could be highly profitable both now and in future. Indeed, last year the bank made £5.9bn in profit after tax. Given that the business is currently valued at £32bn, its price-to-earnings ratio of less than six looks attractive to me. As the UK’s largest mortgage lender, the company has economies of scale and can profit when the economy does well.
All of that bodes well for Lloyd’s ability to pay a dividend. Indeed, last year the company paid out only £877m of dividends to ordinary shareholders despite its mammoth profits. It also earmarked £2bn for share buybacks. I take that as a sign of management confidence. It could also make it easier for the company to raise dividends in future. If the company pays back its own shares and cancels them, the smaller remaining number of shares could in future receive a higher dividend without increasing the total payout cost to the company.
Some risks at Lloyds
However, although I think the bank’s strong position in the UK is good for profits now, what about the future?
Lloyds’ heavy exposure to a single market concentrates its risk. If the UK enters a recession or the housing market falls, it could hurt borrowers’ ability to repay loans. There may also be less demand for new loans. Both things could hurt Lloyds’ profits.
Although the UK banking sector is now healthier than it was going into the financial crisis, a serious systemic problem in the financial system would hurt banks hard. After suspending its dividend during the financial crisis, Lloyds only brought it back in 2015.
On top of that, the Lloyds share price is a fraction of what it was going into that crisis.
My take on the Lloyds dividend
Maybe painful memories of that time have put some investors off Lloyds. That could explain why it trades at what looks like a cheap valuation.
But I also think management has not set out a compelling vision for the Lloyds dividend. The bank and its peers were forced to suspend the dividend during the pandemic. But when the Lloyds dividend came back it was at a much lower level than before. Money used to fund buybacks could have been used to support a much more generous dividend – but it was not.
For now, I hope the bank will continue to increase its dividend. Its sustainable dividend policy means the bank aims to keep raising the dividend and it can comfortably afford to do that at the moment. But if a recession comes, things could change fast.
