The undervalued UK bank shares tipped to rally

Credit: Mike Kemp/In Pictures via Getty Images.

Big upsides for Barclays (LSE:BARC) and NatWest Group (LSE:NWG) shares have been forecast after a City firm said the UK banking sector traded at an undeserved discount to European peers.

Berenberg regards the lenders and Lloyds Banking Group (LSE:LLOY) as “attractive as ever”, offering sustainably improving returns that are underpinned by robust balance sheets.

• Our Services: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

It argues for a re-rating from a multiple of 7.5 times two-year forward earnings, but even without one it says UK banks can generate 15% total shareholder return (TSR) a year.

The bank sees the most potential at NatWest, with shares backed to move 30% higher to 860p, and at Barclays based on an estimate for a 20% improvement to 620p.

Lloyds is seen adding about 10% to 117p but is Hold-rated as it already trades at a 20% premium to its domestic peers.

The UK banks have delivered 130% TSR over the past two years, boosted by improved profitability on the back of higher interest rates and their material distributions via dividends and share buybacks.

However, Berenberg views this performance as a catch-up effect of past earnings upgrades and that the banks are still missing a re-rating.

The current absolute valuation level is back to that of late-2021, when interest rate expectations began to rise from the lows that followed the Covid-19 pandemic.

In relative terms, the UK banks trade at a 20% discount to European banks and well below their 8% average discount over the past 15 years.

This deeper discount partly reflects the risk of higher taxes and the potential for conduct and legal liability overhangs to erode earnings.

• Brexit: biggest winners and losers 10 years on
• Bill Ackman talks IPOs, SpaceX and favourite tech stocks
• Sector Screener: do BP shares still have investment potential?

However, Berenberg argues that these are also valid risks for a number of European banks.

It added: “Given the expected level of UK banks’ profitability in outer years, which is on the upper end of what they generated during the past 15 years, we believe the UK banks should also be trading at higher multiples than they are currently.

“In this regard, we see the most upside for Barclays and NatWest.”

Barclays trades at about 7.3 times the City’s two-year forward price/earnings multiple, Lloyds at 8.2x and NatWest at 7.4x. In aggregate, the UK banks’ 7.5x  multiple is below the 8x average.

Berenberg added: “While the UK economy is navigating a challenging period due to geopolitical uncertainties, UK banks are well equipped to weather near-term risks, in our view.

“We believe this resilience and the ability of UK banks to grow their earnings faster than the sector over the next three years remain unrewarded.”

The City firm expects net interest income (NII) to remain the dominant driver of UK banks’ earnings growth over the next three years.

The structural hedge, which involves rolling interest rate swaps that lock banks’ floating deposit income into fixed rates, will be the key driver and account for 50% of NII by 2028.

The hedge contribution provides earnings visibility as maturing hedges are reinvested at current swap rates, which remain materially above average hedge yields.

Berenberg expects modest growth in most UK product markets in the near term before an acceleration as credit demand normalises and undersupply supports house price appreciation.

• Stockwatch: take profits or risk going hungry in AI moving feast?
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis
• New target as FTSE 100 high-yielder boosts confidence

In its view, market share gains in UK mortgages are likely to continue for Barclays and NatWest.

While payout ratios should remain stable, rising earnings will result in higher distributions. This means it sees the total yields of UK banks rising from 7-8% currently to 10-11% by 2028 via dividends and buybacks. This compares to a sector average total yield of 7-8% per year.

For 2026 and 2027, the bank’s forecasts show Barclays distributing 65-70% of its annual profits - split 30% cash dividend and 40% buybacks.

Lloyds is set to return 90-95% (including 40%/45% dividend) and NatWest 75-80% of its annual profits, including 50% cash dividend and 25-30% of buybacks when they resume following this year’s pause.

The capital distributions translate to an average annual total yield of 8% for Barclays and NatWest and 9% for Lloyds.