Shares in Royal Bank of Scotland Group (LSE: RBS) (NYSE: RBS.US) have climbed 9% so far this year, and are 15% higher than they were six months ago.
Despite these gains, the bank trades at around 89% of its tangible book value — which seems to be an attractive discount, until you look a little more closely at the company’s plans, as I did recently.
Bad, bad bank
In its third-quarter results, RBS confirmed the creation of an internal bad bank, which will manage £38bn of the bank’s bad loans. RBS says that its ambition is to accelerate the run-down of these high risk assets, and to dispose of between 55% and 70% of them over the next two years.
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According to RBS, this strategy is likely to mean ‘a significant increase in impairments in Q4 2013’, which will lead to a ‘substantial loss for the full year’. It could also lead to further falls in the bank’s book value, as dodgy loans are taken off the balance sheet.
I reckon this trend could continue into next year, as it’s hard to sell bad loans quickly unless you are willing to mark them down. By way of comparison, Lloyds Banking Group sold £1.8bn of bad loans for an average loss of 35%, late last year.
As a result of RBS’s strategy of accelerating the disposal of its bad debts, I suspect that next year’s consensus forecasts for earnings per share of 24.1p are somewhat optimistic, and expect to see further downgrades as the year progresses.
How to value RBS?
In fairness, RBS is not an easy bank to value. Not only does the government own 80% of its shares, but it’s also failed to make a profit since 2007, and is not allowed to pay dividends.
To make matters worse, if the bad bank is successful in disposing of non-core assets, then RBS’s book value could fall significantly, unless new lending accelerates at a dramatic rate.
Given this situation, you might think that investors would be cautious in their valuation of RBS. Surprisingly, that’s not the case — based on 2014 forecast earnings, RBS is currently valued more richly than any other UK bank:
| Bank | 2014 forecast P/E |
|---|---|
| Barclays | 9.7 |
| Standard Chartered | 9.7 |
| HSBC Holdings | 11.0 |
| Lloyds | 12.4 |
| RBS | 15.6 |
I can’t understand why RBS shares trade on a higher P/E rating than any other UK bank — but I am sure that better value exists elsewhere in the banking sector.
