Image source: NatWest Group plc
It's been a banner year to own shares in High Street Bank. NatWest (LSE: NWG). The share price is up 65% over the last 12 months. Not only that, but it yields 4.9% even after that price increase.
But with a price-to-earnings ratio of 7, the NatWest share price still looks cheap by that measure. Since earnings aren't always the best way to value bank stocks, I also take the price-to-book ratio into account when weighing whether to add them to my portfolio.
On that basis too, NatWest shares look quite cheap given its strong brands, large customer base and proven profitability. Its price is around 0.9, which is cheaper than the fair value of 1.
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Banking income can vary greatly
The challenge with book value or earnings as a valuation metric when evaluating bank stocks is that both can change, sometimes very quickly.
If the housing market suddenly collapses or household incomes contract sharply, the number of borrowers who fall behind on their payments may increase. That can lead to lower profits or even going from profits to the red.
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If real estate prices fall, a bank's book value is likely to fall as well. After all, that value is based on the assets (such as mortgaged buildings) it carried on its books. Therefore, lower real estate prices may mean lower book value.
For now, there are no immediate signs that either thing is about to happen on a large scale. But in the longer term, I feel less confident. The economy remains lackluster, while real estate prices remain high due to historic long-term affordability measures.
Limited supply and strong demand can help support prices, but even when demand outstrips supply, property prices can fall if homeowners struggle to pay for them.
Where things could go from here
That's a risk I'm worried about right now when it comes to the share prices of British banks, including NatWest. In fact, it's a key reason why I don't own the stock right now and have no plans to add it to my portfolio.
The government's sale of its stake in the bank (a legacy of a financial crisis-era bailout) does not appear to have affected NatWest's share price and, from a valuation perspective, the bank still looks quite cheap.
Meanwhile, the longer the business continues to perform well, the more confident I think some investors will feel that a hard economic landing is a downside risk. On that basis, I think that even after its recent rise, NatWest shares could continue to rise from here.
I wouldn't be surprised to see them at a higher price a year from now, although I don't think the performance of the business justifies anything like another 65% rise in the share price in the next 12 months.
However, despite that optimism, I will remain in the dock until there is clearer evidence of continued strong performance in the global and UK economy.
