Shareholders in Royal Bank of Scotland Group (LSE: RBS) have needed patience as the bank has clawed its way back to profitability. But Friday’s results suggest to me that the waiting period may now be over.
In this article, I’ll explain why I think the shares are cheap at current levels, and why I expect them to beat the market over the next couple of years.
Dividend bigger than expected
Friday’s figures revealed that shareholders will get a much bigger payout than expected for 2018. The bank will pay a final dividend of 3.5p per share and a special dividend of 7.5p per share. Together with the 2018 interim dividend of 2p per share, this gives a total payout of 13p per share for 2018. That’s equivalent to a yield of 5.2% at the last-seen share price of 247p.
This generous payout was made possibly because the group’s pre-tax profit rose by 50% to £3,359m, slightly ahead of analysts’ forecasts. Although the group’s revenue only rose by 2% to £13.4bn, costs fell by £756m and bad debts of £398m were 19% lower than in 2017.
These changes combined to help increase the bank’s return on tangible equity — a key measure of profitability — from 2.2% to 4.8%. Although this is still too low, it’s a solid improvement and a step towards its 2020 target of at least 12%.
My target price is 325p
As a shareholder, I’m pleased with the progress made this year. But I’m hoping for more. At the heart of my valuation model is the assumption that this bank (and others) will be able to return to more sustainable levels of profitability.
The role model here is Lloyds Banking Group, which reported a return on tangible equity of 13% for the first nine months of 2018. RBS is obviously some way below this at the moment, but Lloyds’ performance suggests to me that the RBS target of “more than 12%” by 2020 may be achievable.
At the moment, RBS shares trade at a 15% discount to their tangible net asset value of 286p per share. In contrast, Lloyds’ shares trade at a 10% premium to tangible net asset value.
If RBS shares were valued at the same level as Lloyds’, my sums suggests the RBS share price could rise to about 325p. That’s about 30% above the current share price.
What happens next?
The government still has a 62.4% stake in RBS. The Treasury sold 7.7% of the bank’s shares last June but, since then, there’s been no word on the timing of any further sales. Some analysts have suggested today’s results — earlier than expected — may be a sign that the government is gearing up to sell more stock.
I’d welcome this but I don’t know how likely it is. What I do know is that RBS chief executive Ross McEwan seems to be doing all the right things. The only remaining concern is the possible impact of Brexit. McEwan sounded a cautious note on this on Friday, warning that bad debts could rise this year.
I don’t know what will happen next. But RBS shares offer a 2019 forecast dividend yield of 4.5%, and the bank’s performance is improving. I continue to rate the shares as a buy.
