Image source: NatWest Group plc
It has been a good year to own high street bank shares NatWest (LSE: NWG). The share price has risen 65% over the past 12 months. Not only that, it yields 4.9% even after that price increase.
But with a price-to-earnings ratio of 7, NatWest's share price still looks cheap on that ratio. Since earnings are not the best way to value bank stocks, I also consider price when weighing whether to add them to my portfolio.
On that basis too, NatWest shares look cheap given its strong brands, large customer base and proven profitability. They come in at about 0.9, which is cheaper than the fair value of 1.
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The bank's income can be slow
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 crashes or household incomes contract sharply, the number of borrowers who fall behind on their payments could increase. That can lead to lower income or even going from profit to red.
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If property values fall, the bank's book value will likely fall. After all, that amount depends on the assets (such as mortgaged properties) that it had on its books. So lower property prices can mean lower book value.
At the moment, there is no immediate indication that anything will happen on a large scale. But in the long run, I feel less confident. The economy remains fragile, while real estate prices remain high by historic measures of long-term affordability.
Limited supply and strong demand can help support prices, but even when demand exceeds supply, property prices can fall if homeowners struggle to afford them.
Where things can go from here
That's the risk I'm worried about right now when it comes to the share price of British banks, including NatWest. Indeed, it is the main reason that I do not currently own the share and have no plans to add it to my portfolio.
The government selling its stake in the bank (a legacy of the bailout during the crisis) appears not to have hurt NatWest's share price and from a valuation perspective the bank still looks cheap.
Meanwhile, the longer the business continues to do well, the more confident I am that some investors will feel that the economic downturn is dangerous. On that basis, I think that even after their recent run, NatWest shares can only keep going up from here.
I wouldn't be surprised to see them at a much higher price a year from now, although I don't think business performance warrants anything like another 65% increase in share price over the next 12 months.
Despite that hope however, I will remain on the bench until there is clear evidence of continued strong performance in the global economy and in the UK.
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