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Play The Percentages With Royal Bank Of Scotland Group plc

The forward price-to-earnings (P/E) ratio — share price divided by the consensus of analysts’ forecasts for earnings per share (EPS) — is probably the single most popular valuation measure used by investors.

However, it can pay to look beyond the consensus to the spread between the most bullish and bearish EPS forecasts. The table below shows the effect of different spreads on a company with a consensus P/E of 14 (the long-term FTSE 100 average).

EPS spread Bull extreme P/E Consensus P/E Bear extreme P/E
Narrow 10% (+ and – 5%) 13.3 14.0 14.7
Average 40% (+ and – 20%) 11.7 14.0 17.5
Wide 100% (+ and – 50%) 9.3 14.0 28.0

In the case of the narrow spread, you probably wouldn’t be too unhappy if the bear analyst’s EPS forecast panned out, and you found you’d bought on a P/E of 14.7, rather than the expected 14. But how about if the bear analyst was on the button in the case of the wide spread? Not so happy, I’d imagine!

Royal Bank of Scotland

Today, I’m analysing Royal Bank of Scotland (LSE: RBS) (NYSE: RBS.US), the data for which is summarised in the table below.

Share price 312p Forecast EPS +/- consensus P/E
Consensus 20.2p n/a 15.4
Bull extreme 34.0p +68% 9.2
Bear extreme 10.1p -50% 30.9

As you can see, the most bullish EPS forecast is a whopping 68% higher than the consensus, while the most bearish is not much less divergent at 50% lower. This 118% spread is far and away the widest of the FTSE 100’s big five banks, giving us credible earnings projections, which produce, at one extreme, a P/E in single digits and, at the other, a P/E of over 30.

In contrast to a company such as National Grid (which I wrote about here), where EPS forecasts are so tightly grouped that we can properly refer to a ‘consensus’ among analysts, the word hardly seems fitting in RBS’s case. While we can have a high degree of confidence in the earnings multiple we’re paying for National Grid, RBS is currently a far chancier proposition — so much so that buying the shares on the basis of the P/E could better be described as a punt than an investment.

The reason, of course, is that RBS’s business remains in a state of considerable complexity and flux, as it restructures and recovers from the financial crisis. There are a lot of sensitive moving parts in banks at the best of times, but with visibility being particularly poor at RBS, it’s no surprise that analysts’ earnings models are producing a dramatically wide range of EPS forecasts, and forward P/Es. As such, it’s nigh on impossible to judge whether RBS is attractively priced on forward earnings right now.

Of course, the P/E isn't everything -- particularly when it comes to analysing banks, which are a little different to most other businesses.

If you're looking to invest in this sector, or already own shares, I urge you to take a look at the Motley Fool's exclusive FREE report, "The Essential Guide to Investing in Banks".

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