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Why this banking stock is set to soar by 25%+

License: CC0 Public Domain.

The emergence of ‘challenger’ banks in the UK has been encouraged by the government and regulator in recent years. It is hoped they will provide competition among what has been a relatively concentrated market structure, which would provide consumers with greater choice. In addition, challenger banks also offer an investment opportunity, since their growth rates tend to be much higher than their longer-established peers. One such challenger bank has reported results today and I think it could be set to soar by 25%+ over the medium term.

A strong quarter

CYBG (LSE: CYBG) has traded in line with expectations in the first quarter of the year. It has recorded sustainable growth in assets and deposit balances, while its net interest margin has remained broadly stable. It currently stands at 222 basis points and while the bank has faced uncertain and competitive market conditions, it was able to increase its mortgage book at an annualised rate of 4.4%. This is ahead of the wider market and was largely due to positive momentum within the new small and medium-sized enterprise lending segment.

In addition, deposit balances increased by 4.7% on an annualised basis, with investment in new products across the current account and savings range yielding upbeat performance. Further investment is being made in network optimisation and branch automation, which should help the bank to reach its target of a 5% reduction in net underlying costs in the current year.

Economic outlook

Although CYBG reports minimal disruption from Brexit, this does not necessarily mean it will avoid the the uncertainty that may arise as negotiations progress. Although it has a common equity tier 1 (CET1) ratio of 12.8% and a solid balance sheet in terms of asset quality, CYBG lacks diversification when compared to other banking stocks such as Santander (LSE: BNC).

Santander operates across the globe, and while the UK is a key market for the business, its geographic diversification may enable it to better ride out any challenges posed by Brexit. As a result, Santander may be a lower risk option than CYBG over the coming months.

Upside potential

However, CYBG has significant upside potential and I think that its shares could be set to rise by 25%+ over the medium term. It is forecast to record a move from loss to profit in the current year, which has the potential to boost investor sentiment. In the 2018 financial year, its bottom line is forecast to rise by 18% and this puts it on a price-to-earnings growth (PEG) ratio of only 0.8.

This indicates there is significant upside, since CYBG has a forward price-to-earnings (P/E) ratio of 13.4. If its share price rises by 25%, this would mean a forward P/E ratio of 16.8. Given its double-digit growth prospects, this would suggest fair value.

While Santander may be a lower risk option due to its diversity, it is expected to record a rise in its bottom line of just 3% this year, followed by 9% next year. While this represents an improvement on last year, its P/E ratio of 11.8 suggests it may struggle to deliver share price gains which are as high as those of CYBG. So, while Santander appears to be a sound long term investment, CYBG could deliver outperformance versus its sector peer.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.