I’m targeting 60% upside from Royal Bank of Scotland Group plc

On Friday morning, Royal Bank of Scotland Group (LSE: RBS) reported a £7bn loss for 2016. It’s the ninth consecutive annual loss and was even bigger than City forecasts of £6.1bn suggested it might be.

It would be easy to dismiss RBS as a basket case. But I’m not convinced by that argument. In this piece I’ll highlight some key numbers from Friday’s results and explain why I’ve recently added the shares to my own portfolio.

Look through the noise

The bank’s after-tax loss of £6,955m for 2016 “included litigation and conduct costs of £5,868m, restructuring costs of £2,106m, the final Dividend Access Share (DAS) dividend of £1,193m and Capital Resolution disposal losses and impairments of £825m.”

These costs all have one thing in common. They aren’t part of normal operations for a healthy bank. The Dividend Access Share payment was required as a condition of RBS’s bailout so that it can restart dividend payments at some point in the future. The litigation and conduct costs may continue into 2017, but the provisions made last year are intended to cover the worst of the bank’s outstanding liabilities.

Common sense and the example of other UK banks suggest to me that RBS will eventually resolve these problems. At that point investors will start to become more interested in what lies underneath. In my view this is where the opportunity lies for value investors.

Core profits are attractive

The bank’s 2016 results suggest to me that the core RBS could be quite attractive to investors.

Excluding the exceptional costs I’ve outlined above, RBS reported an adjusted operating profit of £3,674m last year. Although that is 16% lower than the £4,405m the bank earned the year before, key underlying performance measures were stable or improved.

The group’s net interest margin — a measure of profit on lending — rose from 2.12% to 2.18%. The adjusted cost-to-income ratio fell from 72% to 66%. The only significant disappointment was that the bank’s adjusted return on tangible equity fell from 11% in 2015 to 1.6% in 2016. However, this improved in the latter part of the year and rose to 8.6% in Q4.

Indeed, when we look at the real core of the bank — personal and corporate banking, plus the NatWest Markets businesses — we can see that performance was very stable last year. Operating profit rose by 3.9% to £4,249m, while adjusted return on tangible equity was 11.1%, compared to 11.2% in 2015. These figures suggest to me that the core bank trades on a P/E of about 10.

Can RBS fix this thing?

RBS’s balance sheet remains strong after this year’s losses, with a common equity tier 1 (CET1) ratio of 13.4%. Chief executive Ross McEwan expects 2017 to be the final year during which it faces significant legacy costs.

The bank is targeting a full return to profit for 2018. Further cost-cutting is planned for this year and it expects to be able to deliver modest growth in lending and core revenues.

My view is that as its problems fade away and profits become more robust, RBS shares are likely to re-rate towards the bank’s book value of 418p. In my view, a gain of 50-60% from current levels is quite possible over the next few years.

Don't put all your eggs in one basket

Investing in RBS isn't without risk. Even if things go well, it may be several more years before the bank is able to pay a dividend again.

If you're looking for a combination of dividends and growth, I'd strongly suggest that you consider the stocks featured in 5 Shares To Retire On, alongside RBS. These five stocks have been handpicked by the Fool's expert analysts for their long-term growth and income potential.

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Roland Head owns shares of Royal Bank of Scotland Group. 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.