Spot the growth potential

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The Lloyds-TSB takeover of Scottish Widows last week offers us a timely chance to investigate the story behind companies which are given a high price tag by the stock market because they have a lot of anticipated future growth built into the share price.

Your job is to work out for yourself where that growth is going to come from, and whether it is really going to materialise.

When you do find a great growth company the rewards can be handsome, as investors in Microsoft and Dell, among others, have found. Be careful, though, and do your Foolish homework first.

Lloyds TSB has successfully managed to grow its earnings over the past few years, and it's useful to examine how it has done it. If you think now might be a good time to buy the bank's shares, you should first know a bit about how companies can grow their earnings.

There are two main ways they do this. The first is organic, or like-for- like, growth. A company does this by increasing its turnover in its existing business (by a retail chain selling more products through its stores, for example).

The other type of growth comes from expansion. This will generally be achieved by expanding the existing business into new markets (opening new stores in the case of a retailer, for example) or by making acquisitions (a retailer buying up a competing chain of shops, for instance).

Lloyds TSB's growth in recent years has been driven by acquisition, and the company has proved it can make these deals profitable using the greater size of the merged business to reduce costs and by cutting out duplicated areas of business. As well as TSB, Lloyds owns Cheltenham & Gloucester, the former building society, and Abbey Life, a life insurance company with a tied sales force.

Since TSB joined the group in 1995, the bank's growth has been in danger of slowing down. The cost savings from its integration of Abbey Life have been fizzling out. Investors have been waiting for a new acquisition for some time, and the perceived difficulties of finding a suitable target have caused a number of them to lose confidence. As a result, the company's share price has underperformed the rest of the banking sector by around 20 per cent so far this year.

Even so, the Foolish investor will note that Lloyds TSB's earnings growth exceeds that of the rest of the sector. Investors who have bought into companies because they have a record of fast growth are often upset when growth slows, as it must at some point.

Then the share price falls as impatient investors bale out. A good example of this is Rentokil Initial. This company has prided itself on its ability to grow its earnings per share by at least 20 per cent every year. It has been so successful at this that it even made 20 per cent growth one of its key targets. A company cannot grow at that rate forever. As a result, when the company warned that growth for this year is expected to come in at "only" 10 to 15 per cent - still a respectable rate for a mature company - the warning induced panic and the share price has since plunged to half its previous level.

To get back to Lloyds TSB, Foolish investors are always patient and don't jump because growth slows down. Scottish Widows is a coup for the bank. The Royal Bank of Scotland, for example, had closer commercial ties with Scottish Widows and might have had its eye on the insurer; now investors will be looking at RBS and asking if it is going to look elsewhere to boost its assets.

There are still plenty of opportunities for banks to make acquisitions out there, but future expansion for Lloyds TSB will almost certainly have to be in continental Europe or further afield. It would run the risk of encountering problems with the monopolies and mergers police if it bought many more slices of the British insurance or savings market.

n Motley Fool, www.fool.co.uk

ASK THE FOOL

My friend tells me that she has an interest-only mortgage. What is that?

AJ, Doncaster

The Fool responds: An interest-only mortgage is simply one that has no tied repayment method, and it is up to you to make sure you have enough cash to pay off the original capital sum at the end. Your friend obviously believes she can get returns from her investments that will beat the interest rate she is paying on her mortgage. She is taking a bit of a risk, though, and most people feel better paying for their houses via a repayment mortgage.

n If we publish your question, you'll win a Fool baseball cap. E-mail UKColumn@fool.com or post to Motley Fool, 79 Baker Street, London W1M 1AJ.