Good value in Bank of Scotland

Bank of Scotland faces a tough strategic choice; it can continue growing organically, by winning market share in the bitterly competitive retail banking market, or it can try to "do a Lloyds" by buying a building society.

Tying up with a building society makes commercial sense, with the vast majority of the bank's 450 branches north of the border and only a handful of regional offices in England. But yesterday's results showed that a takeover is far from a necessity.

Full-year figures to February, showing a 14 per cent rise in underlying profits before provisions, were bang in line with expectations and pleased the market. With the 23rd consecutive rise in the dividend, it is no surprise that the bank's shares have outpaced their peers for several years now.

With the current merger fever in the society sector, there is no shortage of candidates. The bank claims at the moment to be "ambivalent" about splashing out for a society. If, on the other hand, a society appeared that was prepared to sell up at close to book value, Bank of Scotland says it would consider it.

The 14 per cent rise in operating profit to £650m, in a year when most high street banks saw flat or lower earnings, reflect good gains in market share on the retail side, with lending up10 per cent to £24.8bn.

Pre-tax profits were £449.7m, a 67 per cent rise from £268.7m last time. The figures were boosted by a large drop in bad-debt provisions - while at the same time being flattered to some extent by an £11m dividend from a stake in the business development capital group 3i. The dividend grew by 15 per cent to 5.82p.

Bad debt provisions dropped by a third to £221.5m from £313.9m during the year, reflecting the economy's recovery from recession. The bank thinks that the sector has not yet reached the bottom of the provisioning cycle, and there may be another one or two years of further reductions.

Investors may be less than excited by the bank's low yield but it has a popular following as a growth stock.

The ratio of costs to income is an attractive 50 per cent, compared with an industry average of 60 per cent, and a return on capital of 20 per cent is in line with rivals. The key tier one capital ratio, which measures financial strength, is lower than its over-capitalised peers' at 6.1 per cent.

On a prospective price-earnings ratio of 8.6, Bank of Scotland looks undervalued by comparison with similarly-rated rival institutions, which are growing more slowly. Good value.