Handicapping Citigroup's Future

At $30 a share, Citi is tempting. But how do you reconcile its undervalued earnings power with its incalculable risks?

It's hard to imagine the demise of Citigroup (C ), with bloodlines dating back to 1812 and a market value greater even than IBM's (IBM ). Yet the risk is implicit in government investigations and investor suits. If Citi were held criminally and civilly liable for exploiting or mismanaging the conflicts of interest inherent in financial conglomerates, the potential fines, sanctions, and jury awards could be incalculable.

Incalculable is one tough word for investors. And it's why Citi's stock rests lately near $30 (chart), a plunge in market value this year of more than $110 billion-- which makes it tempting, particularly in light of profit expectations. Even bearish analysts see Citi earning about $3.25 a share next year. So today, Citi is selling for nine times the low estimates of 2003 profits, while such lesser rivals as Prudential Financial (PRU ), Wells Fargo (WFC ), and Goldman Sachs (GS ) go for 13, 14, and 15 times low-end forecasts, respectively.

How might an investor reconcile Citi's incalculable risks with its apparently undervalued earnings power? One answer is to weigh the odds of various scenarios, bullish and bearish, and then use those odds to estimate the stock's fair value. CEO Sandy Weill is maintaining that Citi has "found nothing illegal" in its operations. Yet the risk of disaster for Citi has not been so great since 1991, when its very solvency came into question. Why not blend the good and bad scenarios to see what they say about Citi's stock price?

Weighing probabilities in this way is a familiar tool of corporate profits forecasters. But a Morningstar stock analyst named Craig Woker recently applied it to the special circumstances facing Citi (and also to its fellow traveler in trouble, J.P. Morgan Chase). Woker was stumped by the gap between Citi's market value and his estimate of its fair value, $53 a share, based on future cash flows. One problem, he knew, is that cash-flow models don't take account of potential legal penalties. By the same token, he saw no reason to assume that the market has been correctly sizing up Citi's extraordinary risks.

So Woker came up with five scenarios, from Citi escaping punishment to a worst case in which extreme legal liabilities swamp assets and investors wind up with zero. He assigned different probabilities to each and arrived at a $43 fair value for Citi. How he gave odds to different scenarios was arbitrary, Woker told me. "It ends up being educated guesswork," he said, "but it helps people put things in perspective."

I approached the problem a little differently (table). Instead of evaluating Citi's cash-flow potential, I first looked to see at what multiples of earnings and book value Citi has traded over the past decade. The average annual multiples reported by Standard & Poor's range widely, from as little as six times earnings and 1.8 times book value back in 1992, to 21 times earnings and 3.7 times book in recent years.

Next, I imagined four scenarios: First, that Citi's shares command anew the high multiples they saw last year; second, that they win only average multiples; third, that regulators order Citi broken up, and it's liquidated at book value; finally, that Citi is held liable for extreme wrongdoing, wiping out shareholders. With a bullish hypothesis on the stock, I aimed to err on the down side by using the low-ball $3.25 estimate of 2003 earnings and overweighting the two ugly scenarios, giving each 10% odds. Together, that meant some drastically bad outcome got a 20%, or 1-in-5, chance.

The result? What I call Citi's PWV, or probability-weighted value, came to $39 a share. With the stock lately near $30, this analysis makes Citi look like a bargain, although a bit less of one than Woker's pencilwork found. If the shares tempt you, here's my advice. Don't assume these figures are right. Size up Citi's special situation yourself. Dream up other scenarios. Assign different odds. Do the math. Calculate Citi's incalculable risks.

By Robert Barker

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