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Qualiport

[ June 28, 2000 ]

Looking at Lloyds

By Maynard Paton (TMFMayn)

Carburton Street, London --Continuing my review of the Qualiport companies that have taken a back seat in recent months in terms of coverage, today I'm turning my attention to Lloyds TSB (LSE: LLOY).

First, let me make an admission. When it comes to banks, I have an investment blind spot. Part of it is to do with the accounts. It's relatively straightforward to peruse through the conventional books of a software company or restaurateur and determine their traditional financial performance measures. But with banks, the accounts are presented in a totally different and complex manner. I can calculate the return on equity and the cost to income ratios (the banking equivalent to operating margins), but that's about it. Don't ask me about the importance of Tier 1 capital ratios or risk-weighted assets.

My accounting unfamiliarity is compounded by the nature of banks and their future profits. Whereas, say, an expanding restaurateur can open another restaurant to gain additional profits, it's not that simple with a "mature" bank. Banks have a very large dependence on the interest rate cycle. But don't ask me how much a half-percent hike in interest rates will affect sector profits either.

Couple my ignorance by the fact thousands of Wise analysts pour over the banking sector and economic data every day, and so I've always considered there to be little point, for me anyway, to look at this industry in an attempt to try and outperform the stock market.

A favour from the stock market

But, the stock market moves in mysterious ways. The divergence earlier this year of the valuations between technology, media and telecom companies, and those companies that operate in more traditional industries, may have done ignorant investors like me a favour.

Although I have only a cursory knowledge of banks, the low valuations afforded to this seemingly unloved sector, as we'll see, may come to my rescue in terms of making an investment decision. At this point, the words of Ben Graham spring instantly to mind.

"The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future". Or in other words, I don't have to have a full knowledge of the sector and the ability to forecast near-term profit performances in order to judge where any bank stands in terms of it's valuation.

Instead, if I apply prudent and conservative forecasts, then my lack of in-depth knowledge of the industry and the exact fortunes of a bank in the years to come will be minimised by the margin of safety applied in the valuation calculations.

Valuation

Although TMFs Googly and Ralegh have considered return on equity and price to book as banking valuation tools, in the current stock market climate, I prefer to use a measure apparently long forgotten by the go-go investors of today -- the dividend yield.

The beauty of using the dividend yield, as opposed to many other techniques is that it's simple, it has a ready made valuation benchmark in the form of government gilts, and unlike the earnings yield, it's based on fact and not an accountant's opinion.

Of course, only the historic dividend yield is based on a fact -- last year's payout. With the stock market always looking forward, it's all about trying to judge the future dividend income stream. This though, is perhaps easier than estimating future profits. While profits, especially in the banking sector, never grow in a steady upwards trend, large companies do tend to set a "progressive" dividend policy. In this case, a solid dividend increase each year tries to soothe investors' nerves from the earnings ups and downs.

A few calculations

At the moment, Lloyds TSB shares stand at 622p. In the year to 31st December 1999, Lloyds TSB paid out a 26.6p per share dividend. That equates to a 4.3% historic dividend yield. Brokers forecast that this current year dividend will increase by 18% to 31.5p, and thus the prospective dividend yield becomes 5.1%. Comparing those figures to the higher, but static, 5.7% risk-free return from 5-year government gilts indicates that the market has the expectation of higher profits and dividend payments from Lloyds TSB in years to come.

Looking at those calculations, it's an interesting exercise to consider Lloyds TSB's fellow industry counterparts.

Bank                             Share Price Prospective Yield
                                     (p)           (%)

Alliance and Leicester (LSE: AL.)    565           5.95
Abbey National (LSE: ANL)            772           5.83
Lloyds TSB (LSE: LLOY)               622           5.06
Woolwich (LSE: WHH)                  281           4.73
Halifax (LSE: HFX)                   617           4.44
Northern Rock (LSE: NRK)             335           4.66
Barclays (LSE: BARC)               1,630           3.52
Royal Bank of Scotland (LSE: RBOS) 1,035           3.14
Bank of Scotland (LSE: BSCT)         604           2.58

There certainly is wide spread despondency within the sector, with those most exposed to the threat of a housing market and mortgage lending slowdown appearing to have the fewest fans. Indeed, at the current share prices, investors assuming that the Alliance and Leicester and Abbey National are to meet their dividend expectations appear to be buying great value at near 6% yields. Indeed, with those two institutions having a yield greater than the return from government gilts, and the likelyhood that the dividends from the two banks will be increased over time, it doesn't take too much mathematics to show a significant undervaluation.

But back to Lloyds TSB. For the following calculations, I'm going to make the broad assumption that Lloyds TSB can continue to dish out increasing dividend payments. After the anticipated 31.5p for this year, I'll go for a 10% annual increase thereafter. Not an overly ambitious expectation, I think, especially as brokers are forecasting a 17% dividend increase for 2001.

Gordon's Growth

The traditional way of determining a company's intrinsic valuation through expected dividends is to discount all future payments to their current net present value. The formula for the dividend discount model is:

     D    D*(1+G)   D*(1+G)^2   D*(1+G)^2
P = --- + ------- + --------- + ---------- + ...
   (1+R)  (1+R)^2    (1+R)^3     (1+R)^4

Where P is the net present value of future dividends, D is the prospective dividend payment, G is the constant growth rate in dividends, and R is the discount rate, or the required investment rate of return.

Summing up that progression to infinity, the formula can be simplified to an expression known as Gordon's Growth Model:

      D
P = -----
    R - G

Thus, for Lloyds TSB, assuming we discount our future dividend stream at a very hefty 15%, our entry price would be:

     31.5p
 = ----------- = 630p.
   0.15 - 0.10

If we assume that Lloyd's will increase their dividend by 10% forever, then the current Lloyds TSB share price of 622p, just under the 630p calculated above, appears great value. However, I'm slightly wary of extrapolating forecasts to infinity, and so on Friday, I will continue with Lloyds TSB and attempt other dividend valuation models. In the meantime though, I think it's fair to say that Lloyds TSB are anything other than overvalued.

Where Next?
Lloyds TSB -- Still Number One?
Fool Buys Lloyds TSB
TMFRalegh on Lloyds TSB
Banking Sector Dissector
Should you yield?
Margin Of Safety
Lloyds TSB discussion board