Before I decide whether to buy a bank’s shares, I always like to look at its return on equity and its core tier 1 capital ratio.
These core financial ratios provide an indication of how successful a bank is at generating profits using shareholders’ funds, and of how strong its finances are. As a result, both ratios can have a strong influence on dividend payments and share price growth.
Today, I’m going to take a look at Royal Bank of Scotland Group (LSE: RBS) (NYSE: RBS.US), to see how attractive it looks on these two measures.
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Return on equity
The return a company generates on its shareholders’ funds is known as return on equity, or ROE. Return on equity can be calculated by dividing a company’s annual profit by its equity (ie, the difference between its total assets and its total liabilities) and is expressed as a percentage.
RBS has not delivered a meaningful return on equity over the last five years, as a long series of asset impairments and exceptional costs have wiped out the bank’s trading profits:
| RBS | 2008 | 2009 | 2010 | 2011 | 2012 | Average |
|---|---|---|---|---|---|---|
| ROE | -23.7% | -4.8% | 0.2% | -2.7% | -8.1% | -7.8% |
Judging from last week’s interim results, 2013 could be the year that RBS returns to profit. The bank reported a first-half pre-tax profit of £1.4bn, and its core tier 1 ratio rose from 10.8% to 11.1%.
How does RBS compare?
One way of assessing a bank’s risk is with its core tier 1 capital ratio, which compares the value of the bank’s retained profits and equity with its loan book.
In the table below, I’ve listed RBS’ core tier 1 capital ratio, ROE and price to tangible book value, alongside those of Lloyds Banking Group and Barclays:
| Company | Core Tier 1 Ratio |
Price to tangible book value |
5-year average ROE |
|---|---|---|---|
| RBS | 11.1% | 71% | -7.8% |
| Lloyds | 13.7% | 136% | 1.6% |
| Barclays | 11.1% | 84% | 6.0% |
RBS continues to be the cheapest of the three big UK banks, based on its price to tangible book value ratio of 71%. However, RBS isn’t necessarily cheap based on its forward earnings potential.
Is RBS a buy?
Analysts expect RBS to deliver earnings of per share of 21p this year, which equates to a P/E ratio of around 15. Interestingly, Lloyds is also valued at around 15 times 2013 forecast earnings, suggesting that City analysts, at least, reckon both banks have decent earnings growth potential.
For my money, RBS offers more upside than Lloyds and could still be a good recovery play, but I feel that it may be quite fully valued at the moment, and rate it as a hold.
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> Roland does not own shares in any of the companies mentioned in this article.
