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This P/E Suggests Royal Bank of Scotland Group Plc Is A Buy

The FTSE 100 has risen by more than 75% since it hit rock bottom in 2009, and bargains are getting harder to find, despite the market’s recent losses.

I’m on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I’m using a special version of the price to earnings ratio called the PE10, which is one of my favourite tools for value investing.

The PE10 compares the current share price with average earnings per share for the last 10 years. This lets you see whether a company looks cheap compared to its long-term earnings.

Today, I’m going to take a look at the PE10 of Royal Bank of Scotland Group (LSE: RBS) (NYSE: RBS.US).

Is RBS a buy?

RBS has reported a loss for the last five years. The bank’s troubles have been well documented, but the question for investors is whether the worst is now over.

Markets remain unsure, not least because the bank remains majority-owned by the government, which is now said to be considering the possibility of breaking up RBS.

Based on price-to-earnings ratios alone, RBS looks very cheap at the moment, especially when its historical earning power is taken into account:

  2013 Forecast P/E PE10
Royal Bank of Scotland Group 12.2 6.0

RBS made a loss in 2012, so I couldn’t calculate a trailing P/E for the bank. Instead, I used the Reuters 2013 consensus earnings forecast of 21.9p per share to calculate a forecast P/E of 12.2 for RBS.

An asset play?

In reality, I wouldn’t recommend investing in RBS (or any company) solely on the basis of its P/E ratios.

For me, the potential appeal of RBS is as a value investment. RBS currently has a tangible book value per share of 459p, which means that today’s share price of 268p represents a 42% discount to tangible book value.

Healthy banks normally trade at, or slightly above, their book value, but I believe some of RBS’ assets may yet be subject to further write downs, especially its UK mortgage portfolio.

Buy RBS?

RBS’s low P/E ratios and discount to book value make it a tempting value investment, and overall, I do believe that RBS shares offer some upside and warrant a cautious buy.

Despite this, I wouldn’t bet the farm on RBS — it isn’t out of the woods yet, and I don’t expect to see its shares trade anywhere near book value for some time yet.

Can you beat the market?

If you already own shares in RBS, then I’d strongly recommend that you take a look at this special Motley Fool report. Newly updated for 2013, it contains details of top UK fund manager Neil Woodford’s eight largest holdings.

Mr. Woodford’s track record is impressive: if you’d invested £10,000 into his High Income fund in 1988, it would have been worth £193,000 at the end of 2012 — a 1,830% increase!

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> Roland does not own shares in any of the companies mentioned in this article.