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The Government Is Selling Royal Bank of Scotland Group plc & Lloyds Banking Group PLC: Which Should You Buy?

It’s finally begun: on Monday night, the government sold 5.4% of Royal Bank of Scotland Group (LSE: RBS).

The deal was done in an after-hours placing to institutional investors at 330p per share, netting around £2.1bn. The sale reduced the government’s stake in RBS to just 73% and means that RBS has now joined Lloyds Banking Group (LSE: LLOY) in a gradual return to the private sector.

One big difference

Chancellor Osborne started selling Lloyds shares when that bank’s share price reached the government’s break-even level. Mr Osborne has decided to start selling RBS shares at a significant loss, given that last night’s 330p placing price is 34% below the government’s 502p breakeven price.

However, it’s worth remembering that RBS has shrunk considerably since its 2008 bailout. Net asset value has fallen from 724p per share in 2009 to just 495p in 2014. A sale at a loss was always the most likely scenario.

Indeed, for investors, the re-privatization of RBS could be a buying signal. Lloyds’ gradual return to private ownership has fuelled a steady rise in the bank’s share price. Based on advice from his advisors at Rothschild’s, the Chancellor is hoping that the same will happen at RBS.

Selling the government’s remaining 73% stake in RBS is likely to take several years. During this time, we should see chief executive Ross McEwan’s turnaround plan take effect, boosting earnings and giving investors more confidence in the quality of the bank’s remaining assets.

RBS vs Lloyds

A return to a share price of more than 400p over the next year or two seems likely in my view, although it’s not a sure thing.

RBS continues to look more expensive than Lloyds, and the timeline for dividends remains uncertain:

 

2015 forecast P/E

2015 forecast yield

2016 forecast P/E

2016 forecast yield

RBS

11.7

0.1%

13.6

1.9%

Lloyds

10.2

3.1%

10.3

4.9%

On these numbers, it’s hard to see any obvious reason to invest in RBS rather than Lloyds.

Yet the willingness of institutional investors to buy £2.bn worth of RBS stock last night suggests that some investors can see the appeal of RBS. One possible reason for this is that whereas Lloyds’ turnaround is now pretty much complete, RBS is just getting started.

For example, Lloyds’ cost: income ratio was just 51.2% in 2014. That means that the bank spent £51.20 to generate £100 of revenue. In contrast, RBS reported an adjusted cost: income ratio of 68% last year, with an unadjusted figure of 87%!

If RBS can reduce costs with as much success as Lloyds, the Scottish bank’s profitability could skyrocket, pushing earnings per share well ahead of current estimates.

However, I’d expect RBS to need another three years to deliver the kind of results we are now seeing from Lloyds — and there’s no guarantee of success.

A simple choice

When making an investment it’s important to consider what you want from it. For investors who want a reliable income immediately, Lloyds is the obvious choice to me.

For investors interested in profiting from a turnaround situation with the potential for dividends in the future, then RBS is the logical investment.

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Roland Head 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.