It's hard to deny that Citigroup's stock is compelling from a valuation perspective. As a general rule, bank investors should try to buy the best bank they can get for the lowest price possible. A popular maxim in the industry is to "buy at half of book value and sell at two times book value."
Citigroup's stock seems to fit the bill. Its shares trade for a 40% discount to book value, according to Yahoo! Finance. And even after you exclude intangible assets its shares are still priced at a 32% discount to its tangible book value, according to data from YCharts.com. That's the cheapest among all big bank stocks.
Shares of Wells Fargo, meanwhile, change hands for a substantial premium to book value. They trade for nearly two times tangible book value and for a 48% premium to book value. Based on valuation alone, then, you'd be excused for thinking that Citigroup is a better buy than Wells Fargo. But as I discuss below, there's a good reason that Citigroup's shares are in the bargain bin.
One of the most important relationships for bank investors to appreciate is the one between profitability and valuation. It's obvious on the surface that highly profitable banks will garner a higher valuation from investors than less profitable banks will. But if you dig a little deeper, there's an important nuance that explains why.
As a general rule, a bank's annual net income should equal at least 10% of its common stockholders' equity. Banks that earn more than this on a consistent basis are said to create value, as their profitability exceeds their cost of capital -- which takes into consideration the opportunity cost of investing in, say, Citigroup as opposed to a low-cost exchange-traded fund that tracks the S&P 500. Banks that earn less than this, on the other hand, are said to destroy value.
Not surprisingly, this threshold weighs heavily on the valuation of a bank's stock. A bank like Wells Fargo trades for a premium to book value because its return on equity exceeds 10%; it was 12.7% last year. Citigroup, on the other hand, trades for such a large discount to book value because it's less profitable, generating a 7.9% return on common equity in 2015.
To a certain extent, of course, the reason that Citigroup's shares sell for a discount to book value while Wells Fargo's have earned a premium is simply because Citigroup has been poorly managed in the past. In 2008, for instance, it reported a loss of nearly $28 billion. But as bad as this sounds (and it is bad!), it leaves room for hope that Citigroup has learned its lesson and will stick to the straight and narrow.
The problem with this thesis is that there are now tangible impediments that will prevent Citigroup from competing on a level playing field against Wells Fargo. The most important of which concerns heightened capital requirements -- the so-called global systematically important bank buffer, specifically.
Because of Citigroup's role in the global financial system, as well as the composition of its operations, it must reserve an additional 1.5 percentage points of its capital relative to Wells Fargo. This, by definition, will drive down its profitability and give Wells Fargo a durable competitive advantage over the $1.7 trillion Citigroup. The net result is that, even in the unlikely event that Citigroup will be able to clean up its act, it will still be fighting an uphill battle against the simpler and perennially better managed Wells Fargo.
In short, there's simply no realistic scenario that would lead me to think that Citigroup is a better stock for investors to own than Wells Fargo.
John Maxfield owns shares of Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.