The following is an extract from last week's regular feature in the Personal Finance section of the Independent On Sunday. Be sure to pick up your copy this Sunday.

My, Haven't You Grown!

The announcement this week of Lloyds TSB Group's (LSE: LLOY) acquisition of Scottish Widows was a very interesting one, and it provides a timely opportunity for Foolish investors to examine the ways in which a company like Lloyds TSB has managed to grow its earnings so successfully over the past few years.

There are essentially two ways in which a company can grow its earnings. Firstly, it can be done by organic, or like-for-like, growth. This type of growth is achieved by a company increasing turnover in its existing business (by a retail chain selling more products through its existing stores, for example). The other type of growth is the growth that comes from expansion. Expansion will generally be achieved in one of two ways, either by expanding the existing business into new markets (opening new stores in the case of a retailer, for example), or by making acquisitions (such as buying up a competing retail chain).

The growth of Lloyds TSB, in recent years, has been achieved by acquisition, and the company has proved itself to be very good at achieving the increased efficiency needed to raise earnings and make such mergers and acquisitions profitable. This has been done by exploiting synergies between the components of the company, using the size of the merged business to reduce the costs that were previously experienced by the constituent businesses individually, and eliminating areas of business that were duplicated across these constituents.

The Lloyds TSB bandwagon, which first got on the road in 1995 when Lloyds Bank merged with TSB to form the core of the company that we know so well today, has been in danger of slowing down as the cost savings from its integration of Abbey Life have been fizzling out. Investors have been waiting for a new acquisition for some time now, 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% so far this year.

Foolish investors need to take note of the way such a company's share price performs. There are a number of companies like Lloyds TSB, that reliably show earnings growth exceeding that of the rest of their sector. Investors in such companies expect this growth to continue, and are not happy when it eventually begins to slow, as it inevitably must at some point. When you look at the share price of an expanding company, you will often find that it appears to be expensive when compared with competitors that are not growing so fast. But this is normal, as investors will have already factored the next few years' expected growth into the price.

A great example of how a quality company can have its share price ravaged by investors comes from Rentokil Initial (LSE: RTO). This company has prided itself on its ability to grow its earnings per share by at least 20% every year. They have been so successful at this that they even made 20% growth one of their key targets. A company obviously cannot grow at that rate for ever, and someday that growth must slow down. This is exactly what happened this year, when the company warned that growth for this year is expected to come in at "only" 10 to 15%. This is still a respectable growth rate for a mature company, but the warning induced panic, and the share price has since fallen by half.

To get back to Lloyds TSB: there are still plenty of opportunities for more acquisitions out there, but future expansion will almost certainly have to be in Europe or further afield, as the possibilities of expanding further in the UK without incurring the wrath of the monopolies police are limited.

So, Foolish investors, when you are investing in a company whose valuation depends on its expected future growth, it is essential to work out where that growth is going to come from, and then ask yourself if you are confident that the expected growth can be met. When you do find a great growth company, the rewards can be handsome, as investors in Microsoft and Dell, amongst others, have found. Be careful, though, and do your Foolish homework first.

My Smartest Investment

I have never been much of an investor, but I bought the minimum allocation of shares in British Telecommunications way back when they floated. I put the share certificate away in a drawer and pretty much forgot about it for years. Recently, I dug it out and checked the share price, and I'm happy to report that my shares would buy me a good few more beers now than the money I originally invested would have done back then. -- GG, Hampshire

The Fool responds: Well done, you have discovered the essence of Foolish investing. Buy shares in good companies, then simply hang on to them and watch the miracle of compounding weave its magic over the years. Now go and put that share certificate back in the drawer, you Fool.

Ask the Fool

Dear 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.

Foolish Trivia

If your grandfather had bought a single share in this company, whose main consumer product is to be found in almost every country in the world, back in 1919, he could have made you a multi-millionaire in his will. Name the company. (Last week's answer -- Barings.)

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