This Thing Is Telling Me To Buy Royal Bank Of Scotland Group plc

There’s a lot of uncertainty surrounding Royal Bank of Scotland (LSE: RBS) (NYSE: RBS.US). Investors are asking all kinds of questions. How much restructuring costs and asset writedowns are there still to come? Will RBS be split into a ‘good bank’ and a ‘bad bank’? How and when will the government sell its 81% shareholding?

Investors who are bearish on RBS dwell not only on these uncertainties, but also on the fact that the company looks very expensive on the popular valuation measure of price-to-earnings (P/E) ratio.

RBS delivered adjusted earnings-per-share (EPS) of 18.3p last year. With the shares currently trading at 370p the P/E is 20.2, improving only marginally this year to 19.9, based on City forecasts of 18.6p EPS.

But it’s not last year or this year I’m interested in. And it’s not the P/E measure that excites me. It’s next year, and the so-called PEG ratio. The PEG uses P/E but also incorporates earnings growth in the valuation. The formula is P/E divided by EPS growth. A PEG number of 1 suggests the P/E is fair value for the level of earnings growth expected. More than 1 suggests an expensive valuation, and less than 1 a cheap valuation.

For the coming year, the analyst consensus for RBS’s EPS is around the 30p mark. That brings the P/E down to 12.3 — an improvement on the current year’s 20, for sure, but still a premium rating within the banking sector.

However, I got rather more excited when I factored in RBS’s earnings growth, using the PEG ratio. Dividing the forecast P/E of 12.3 by the expected percentage EPS growth of 61 (a rise from 18.6p to 30p) gave me a PEG of just 0.2. Now, that’s deep into bargain territory if RBS meets the analysts’ expectations; in fact, EPS a good bit short of the 30p forecast would still be decent value in PEG terms.

Of course, I’d really want to see good earnings growth continue into 2015 as well. While the 61% rate forecast for 2014 isn’t sustainable for any length of time, mid-teens growth would be good enough, and that doesn’t appear to me to be particularly demanding, given the progress RBS has been making.

Coming at the bank from another valuation angle — assets — also gives me cause for optimism. RBS is currently trading at a 17% discount to tangible book value while, in due course, I don’t think it unreasonable to expect the bank to trade at one-and-a-half times book, or perhaps more. Put another way, I reckon there’s a chunky margin to absorb potential asset writedowns still to come.

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> G A Chester does not own any shares mentioned in this article.