Citigroup Undervalued

Valuation of common shares in bank holding companies has become a challenge as the amount of data released in SEC filings has increased. Analysts have responded by narrowing their focus to selected metrics such as the current share price divided by tangible common equity per share and net interest margin. An examination of these measures for six (6) of the largest bank holding companies shows significant variation and suggests that at the present time some are undervalued relative to others.

The bank holding company trading at the greatest premium above its tangible book value as of the close on January 21, 2011 was U.S Bancorp (USB) at 2.89 times. At the other extreme, Bank of America (BAC) and Citigroup (C) trade at the smallest premium to their tangible equity, 1.10 times. The second largest premium observed was for Wells Fargo (WFC), which trades at 2.34 times its tangible equity. It was followed by PNC at 1.65 times and JP Morgan (JPM) at 1.49 times.

Net interest margin (NIM) is the difference between interest income and interest expense expressed as a percentage of interest earning assets. It is normally presented on a taxable equivalent basis and is a measure of relative profitability of a banking franchise. An examination of the fourth quarter net interest margins reported last week in the SEC 8-K filings for the above six companies showed WFC had the highest at 4.16%, followed by PNC at 3.93%, USB at 3.83%, C at 2.97%, JPM at 2.87%, and BAC at 2.66%.

This brief analysis suggests that at the present time BAC and C are undervalued relative to JPM, while WFC and USB are overvalued relative to all the other bank holding companies examined.

Back From The Brink

The financial media is awash with speculation about major bank holding companies increasing dividends and/or buying back shares. While regulatory authorities have acknowledged that bank balance sheets are healing, those same regulators need to remember how difficult it was to raise bank capital within the past few years. Similarly, bank holding company board members need to carefully balance the care and feeding of shareholders with the need to re-establish sound dividend policies that will not have to be reversed.

An overly aggressive dividend policy runs a serious risk of financial embarrassment in the event that a dividend has to be cut in the future. A better option would be for a bank holding company to pay modest quarterly dividends and then augment them with a year-end extra dividend based on the full year results.

A review of the financials for Bank of America, JP Morgan, Citigroup, Wells Fargo, and U.S. Bancorp for the period from 2005 through the third quarter of 2010 suggests that none of them are strong enough to buy back shares. They all remain highly levered financial institutions that have benefited from a period of artificially low interest rates.

These five bank holding companies have significant amounts of goodwill on their balance sheets as a result of acquisitions and accounting treatments accorded by U.S. GAAP. Goodwill is represents the excess of the purchase price of an acquired entity over the fair value amounts assigned to assets acquired and liabilities assumed. Even though goodwill must be tested for impairment every year, its true value is very questionable and excluded from tangible common equity and Tier 1 capital calculations.

As of September 30, 2010 goodwill accounted for 35.60% of Bank of America’s common equity, 32.21% of U.S. Bancorp’s, 29.35% of JP Morgan’s, 21.35% of Wells Fargo’s, and 15.65% of Citigroup’s. Given the significant amounts of goodwill, the degree of financial leverage among the five aforementioned bank holding companies was gauged by reducing their common equity by goodwill and then expressing that more tangible amount as a percentage of total assets. This methodological approach revealed that Wells Fargo had the lowest degree of financial leverage at 7.49%, while JP Morgan had the highest at 5.48%. In between were Citigroup at 7.01%, U.S. Bancorp at 6.53% and Bank of America at 5.85%.

This brief analysis strongly suggests that it would be folly for the major bank holding companies to buy back shares of their common stock and/or establish large dividend payouts so soon after perching on the financial abyss. The general public, as well as shareholders, would be better served by these companies using their earnings to support loan growth. This generation of bankers needs to understand that the public’s appetite for bailing out banks has been satiated for the foreseeable future. Banks must therefore be operated with more common equity and less financial leverage.