Qualiport

[ June 30, 2000 ]

Yielding to Lloyds

By Maynard Paton (TMFMayn)

Rochester, Kent -- On Wednesday, I used the simple dividend yield to put the current valuation of Lloyds TSB (LSE: LLOY) into perspective.

Looking at Lloyds TSB and the rest of the banking sector, it did appear that the constituents of the industry were languishing on low valuations. If you consider that the current risk-free return from 5-year government bonds (gilts) is 5.7%, and that some banks have dividend yields of 5-6%, yields that could expand at a rate of 0.5% per annum, it's not too difficult to see how today's banking valuations are hardly stretched.

With that in mind, let's use the simple valuation philosophy that an investment "bargain" is a company that:

• is large and well-established;
  
• has the prospect of producing a significant rise in dividend payments in years to come, and;
  
• has a prospective dividend yield equal to the return from government gilts.

In this situation, our bargain entry price for Lloyds would be 31.5p/5.7% or 553p.

On Wednesday, using the Gordon Growth Model to discount future dividend streams, I concluded that a share price of 630p would be equal to the net present value of future dividends, should Lloyds TSB pay a 31.5p dividend this year, increase its payout by 10% every year thereafter, and the dividends all be discounted back to today at a chunky 15% rate. But extrapolating any growth rate into infinity is perhaps a little extreme.

A divi alternative

How about this alternative? Firstly, let's extrapolate the dividend stream just five years into the future. For the starting base for this current year, I'll again use the anticipated dividend forecast of 31.5p. And again, I'll go for a 10% annual increase thereafter. Here's how all the numbers pan out.

Year    Dividend per share
               (p)


2000          31.50
2001          34.65
2002          38.10
2003          41.93
2004          46.12
2005          50.73

Fast-forward to 2005, and we could have expected to collect 192p worth of dividends, in the years 2000 to 2004 inclusive, along the way.

Also, let's assume a rough Lloyds TSB future share price by placing the prospective 2005 dividend on a multiple equal to the current risk-free rate of return. In other words, dividing the anticipated 2005 50.73p dividend by the 5.7% medium-term return from government gilts, to give an expected 2005 share price of 890p.

Add together the received dividends and the rough estimation of the share price five years out (192p + 890p) and we arrive at 1,082p. At a current share price of 640p, that equates to an annual compound investment return of 11.1%. The Lloyds TSB share price would have to fall to 538p for a prospective 15% annual investment return.

If we were to calculate the 2005 share price using today's prospective Lloyds TSB dividend yield of 4.92%, then the current 640p entry price would equate to a 13.8% annual investment return over five years. Under this scenario, a 15% compound return would require the Lloyds TSB share price to drop to 608p.

Pros and cons

There are pros and cons to both that valuation model and the Gordon Growth Model. In terms of the upside, there is no regard for the intrinsic value that Lloyds TSB will create with the profits it decides to keep and reinvest. This intrinsic business value is not reflected within any of the valuation calculations -- only the dividends an investor can expect to receive are taken into account.

This is a very cautious approach. Obviously, Lloyds TSB will be busy reinvesting its retained profits over the next few years to maintain a long and profitable future. It won't just be doing the minimum to keep its medium-term income investors happy.

The downside is choosing an acceptable growth rate. Is 10% too high? Pro-forma results for 1999, that include the recently acquired Scottish Widows business, show earnings-per-share (EPS) at Lloyds TSB of 52.1p. Compare that figure to my predicted 50.73p dividend per share for 2005. Will Lloyds TSB really be paying most of today's profits as a dividend in five years' time? It's difficult to imagine. But then again, the prospect of synergies gained by the Scottish Widows purchase and cost reductions by the general move towards a lower cost online banking environment should aid profitability in years to come.

Asian Crisis

It's also worth going back to the dark days of late 1998. Remember the Asian economic crisis? Two institutions widely exposed to that predicament were bankers HSBC (LSE: HSBA) and Standard Chartered (LSE: STAN). Both companies managed 10%-plus year on year dividend increases between 1995 and 1999, a period that encompasses the Far Eastern turmoil. During the turbulence, HSBC shares fell to a 322p low and Standard to 375p. At the bottom, HSBC and Standard had historic dividend yields of 5.18% and 4.93% respectively.

It's surprising to see that, even at the height of the panic, those yields currently match that on offer from Lloyds TSB. Although the two Asian banks have greater longer-term growth prospects that would lead to a generally higher rating, the fact that several UK banks are now yielding the same as the then "deeply troubled" banks gives further anecdotal evidence of the undervaluation of the current UK banking sector.

Lloyds TSB top up?

In this feature, I'm making the (I think) reasonable assumption that the UK's tenth largest company will have a progressive dividend over the next couple of years. Admittedly, the 10% growth rate chosen is debatable.

My general cautious approach -- of only using dividends in the valuation models and ignoring the additional value generated through reinvested earnings -- is with a purpose. I would like to think the approach offsets the inherent risk of investing in a business without an in-depth understanding of how future profits will be created. As I'm not really comfortable with the exact outlook for Lloyds TSB's earnings, it makes good sense to base any valuation model on the expectation of a more reliable dividend stream.

From subsequently fiddling with the figures in the manner featured above, I think that a sub-600p entry price is required for a 15% compound investment return over the next five years. Certainly, should the Lloyds TSB share price drop to around 550p, all things (that is dividend forecasts and risk-free returns) being equal, investors would be in bargain basement territory.

While the Qualiport already has a fair share of highly rated companies, the steady, solid "income" nature of Lloyds TSB gives a sound bedrock for the portfolio. Anyone for a Lloyds TSB top up? On the face of it, it's certainly tempting, even around the current 640p level.

But there are two points that will keep the Qualiport wallet zipped for the time being, though. Firstly, Lloyds TSB interim results are published next month. It may be prudent to wait a week or two and then re-evaluate the Lloyds TSB "story" and valuation. But more important is the consideration of value against business fundamentals. Should we even be considering topping up a holding that operates in a mature, very competitive and cyclical industry? Or would "great value" offset these long-term investment worries?

Vote

A poll for the weekend, to test the popularity of our holding. So, what do you think of Lloyds TSB?

a. A great company that can be bought at any price
b. A good company, but must only be bought at "good value"
c. A fair company, but a "great value" purchase can offset the doubts
d. A poor company and no price would be "too cheap"
e. Don't know/care

Click here to vote.

Where Next?

• Looking at Lloyds
• Lloyds TSB -- Still Number One?
• Fool Buys Lloyds TSB
• TMFRalegh on Lloyds TSB
• Banking Sector Dissector
• TMFTiger asks "Should you yield?"
• Lloyds TSB discussion board
• How to value shares