The risk and return profile of Citigroup (NYSE:C), as analyzed by the Capital Asset Pricing Model over a three-year period, suggests that the stock does not offer a high enough return to compensate for the inherent risk, both relative to the broader market and in comparison to its major competitors. While there has been overall appreciation from 2011 to the present, the firm's most recent one-year return of -3.31% has greatly lagged the S&P 500 return of 19.02%. Moreover, the volatility of the stock is too high, as measured by its beta (1.93), for an average daily return of 0.02% over this period to be justified.
Using the Capital Asset Pricing Model, I gathered daily return data from 2011 to the present date on Citigroup, Bank of America (NYSE:BAC), JPMorgan (NYSE:JPM), Goldman Sachs (NYSE:GS), and Wells Fargo (NYSE:WFC). To determine each company's beta (the company's price volatility relative to the market) and the company's expected return (the average daily return that the Capital Asset Pricing Model says we should receive for the inherent risk), I regressed each company's daily return over the S&P 500 daily return for the period June 2011 to the present. The risk-free rate of 0.04% is based on the current rate of a 3-Month Treasury Bill, and company returns minus the risk-free rate is the dependent variable (Y) in the regression, and market returns minus the risk-free rate (X) is the independent variable.
- Average Daily Return vs. Expected Return: The average daily return shows the actual percentage daily return of each company over the given time period; this is the benchmark that we use against the expected return (the return that the CAPM says we should receive for holding the stock) to determine if a stock is undervalued or overvalued. The expected return is defined as the risk-free rate plus the product of the company's beta and the average daily market return, i.e. Risk-free rate + ß(Average Daily Market Return) = Expected Return. If the stock lies above the Security Market Line, it is undervalued. If it lies below, it is overvalued.
- Beta: This figure tells us how volatile a company's price is relative to its market index. In this case, a company with a beta of less than 1 is less volatile than the S&P 500 Index; a company with a beta of greater than 1 is more volatile than the S&P 500 Index.
- R-Squared: The R-Squared figure indicates the degree of the company's returns that can be explained by the market return, e.g. an R-Squared of 100% means that 100% of the company's returns are "explained" by the market. Conversely, a company with an R-Squared of 0% means that none of the company's returns can be explained by the market return.
- Jensen's Alpha: Jensen's alpha indicates the excess return generated by a stock over its expected return according to the CAPM. If a company has an average daily return greater than the expected return, then the excess return is defined as Jensen's alpha.
From the above analysis, we can see that of the five companies in the study, only Wells Fargo is fairly valued, i.e. with a beta of 1.32, we should expect to be compensated with a return of 0.07% to justify investing in WFC. In this case, we can see that the average daily return of 0.07% exactly corresponds. While WFC has not generated alpha over a three-year period (a return above that which the CAPM says we are entitled to), we are still being adequately compensated for risk. However, the other four companies show a negative Jensen's alpha, with Citigroup and Bank of America showing the lowest values of -0.06% for alpha. This means that the stocks are returning 0.06% less than they should be returning based on their risk measure. For Citigroup, in particular, we would require an average daily return of 0.08% to compensate us for the inherent risk, however, the average daily return of 0.02% is well below this.
It is also interesting to take a look at some of the major financial ratios across the five firms. I decided to compare the five firms in terms of their Operating Margin, Total Cash Per Share, Return on Equity, 5-Year Average Dividend Yield, and Debt-To-Equity. We can see from the below that Citigroup does not excel in any one of the five aforementioned criteria. In particular, it is striking that given Citigroup was a firm renowned for paying high dividends of over 7% before 2009, its 5-Year Average Dividend Yield is below all its competitors but Bank of America. While admittedly, Citigroup's low dividend payments are in many ways due to its low payout ratio, the risk that one takes by investing in the firm in the hopes of a higher yield is too high, in my opinion.
In conclusion, the analysis shows that on a risk basis, investors have not been adequately compensated for investing in Citigroup, and it is my view that unless the firm's ability to pay dividends significantly improves, investors will always be reliant on growth through share price appreciation, which at this moment, carries a great deal of risk given the expected return - the level of risk certainly would not appeal to income-oriented investors at this point in time.
Disclosure: The author is long WFC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.