It's nothing new to investing veteran investors, and new investors are quickly becoming accustomed to the phenomenon as well: Banking stock valuations are reliably lower than those of most other stocks. And this valuation disparity has been even wider than usual in recent months, with rising interest rates putting major downward pressure on dividend-paying banking names.
In a handful of cases, though, investors overshot their valuation targets. Citigroup (C 0.26%) is one of these dramatically undervalued stocks, priced only a little over 7 times its trailing per-share earnings thanks to a 40% pullback from its mid-2021 high.
You may want to use the market's misstep as an entry opportunity before the mistake is caught and corrected.
The market went too far in devaluing Citigroup
Don't misread the message. The general direction in which Citi shares have been moving for the past couple of years makes sense. Higher interest rates tend to crimp demand for loans. At the same time, the inflation driving rates higher takes a toll on banks' already-thin profit margins. Bank stocks' dividend yields must also be adjusted higher to stay in step with rising bond yields. This is usually achieved -- in the short run, anyway -- through lower stock prices.
The issue here is one of degrees. Investors acted far too aggressively in devaluing Citigroup. Priced at only a bit over 7 times the past four quarters' profits and less than 9 times this year's projected earnings (and under 8 times next year's projected per-share profits), this banking stock is at the low end of its long-term price/earnings ratio's range. It's also much cheaper than its peers' shares.
Pessimists will argue the below-average valuation simply reflects future economic trouble that isn't yet being priced into the stock. And to be fair, the argument may hold some water. Citi just recently announced a handful of job cuts, while Citigroup CFO Mark Mason conceded just a few days ago that the United States could suffer a mild recession in the latter half of this year.
These risks are already priced in, though. While Citi shares may be up 22% from October's low, their halving since mid-2021 is the predictive price adjustment. The market seemed to know this proverbial reckoning with inflation and higher interest rates was coming. It just overestimated the size of the toll due.
And to the extent that it helps, know this: The analyst community believes the worst of the banking headwind already passed. While this year's projected per-share earnings of $5.82 will be far lower than last year's $7, the consensus estimate of $6.74 per share next year is a marked improvement, and it's likely the beginning of a longer-term earnings growth trend.
Data source: Thomson Reuters. Chart by author. Revenue figures are in millions of dollars.
What the market may be overlooking here is the fact that while higher interest rates undermine demand for new loans, such a backdrop makes the loans that banks are extending far more profitable than loans made when rates are unusually low. That's one of the key reasons Wall Street's current consensus price target of $57.67 is 16% above the stock's present price.
The kicker: Citigroup stock's current dividend yield of 4% is the highest yield among the United States' major banking names.
Buy Citi at this price while you can
There are counterarguments. Broadly speaking, Citigroup isn't as operationally efficient as other big banks are. Its profit margins are below its peers', while its ROTCE (return on average tangible common equity) measures are also subpar. These aren't nuances would-be buyers should simply dismiss.
That being said, look for these measures to start improving soon. A great deal of Q4's earnings call, held in January, focused on beefing up these measures, with CFO Mark Mason making a point of saying, "As our investment in transformation and control initiatives mature, we expect to realize efficiency as those programs transition from manually intensive processes to technology-enabled ones."
Also know that while Citi may not be as operationally efficient as most of its rivals at this time, its shares largely do already reflect this difference ... and then some. It matters because basic valuation numbers eventually matter, even if the market is currently ignoring them.
Bottom line? Don't make this more complicated than it needs to be. If you're looking for a new banking stock to round out your portfolio, cheap Citi shares can fill that slot quite nicely. Just bear in mind that this low valuation really matters only to true long-term investors.
