Chief executive Stephen Hester’s departure from Royal Bank of Scotland (RBS) last week has made for plenty of headlines. But should you buy or sell? One good way to value a bank is to look at its return on equity (ROE), and then compare its share price with its book value per share (price-to-book, or p/b).
ROE looks at the profit (after tax) made as a percentage of money (equity) invested by shareholders. If a bank makes high returns, then it’s worth paying a premium for – its p/b could justifiably be above one.
Let’s say that, because of the risks involved, investors expect a 10% return from a bank. If the bank has a ROE of 10%, then it would justify a p/b of one, whereas a 5% ROE would justify a p/b of 0.5.
Looking at RBS, City analysts expect a ROE of 2.6% in 2013, rising to 6% in 2016. These are pretty poor returns, given the amount of debt that RBS carries. Yet the shares already trade at 0.6 times book value. So a lot of the recovery looks to be priced in. A new CEO will have to do something radical to deliver meaningful upside from here.
Verdict: avoid
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