Shares of Citigroup Inc. Are Up, but There May Be More Gains Ahead

During the past six weeks or so, Citigroup shares have risen from around $47 to $53 as of this writing, a gain of about 13%. While this is definitely good news for shareholders, there may be more room to run. Specifically, when the Federal Reserve releases the final results of the 2015 "stress tests" on Wednesday, Citigroup shareholders may have another reason to smile.

Why has Citigroup's share price done so well lately?Citigroup reported its 2014 year-end and fourth quarter earnings on January 15, which, according to the chart above, is right around when the recent upswing started. While the earnings results weren't spectacular by any definition of the word, there were a few reasons for investors to smile.

For starters, the bank's capital levels significantly improved from last year, and the bank saw solid gains in some key areas of its business, such as retail banking. In addition, the bank's Citi Holdings division, which houses the "legacy" assets that the bank plans to dispose of, continues to shrink in size, and now holds $98 billion in assets, down from more than $400 billion in 2010. Also, the division was profitable for the full year for the first time since its creation.

Plus, many investors had welcomed the news that the bank had decided to exit 11 of its international markets when it was announced in October 2014, and the most recent earnings reflected a charge related to this. Also included in the $3.5 billion charge the company took this quarter was $2.7 billion in legal expenses. CEO Michael Corbat said that this should cover "a significant portion" of the bank's outstanding legal expenses.

However, we'll find out a lot more next week when we learn how Citigroup fared in the second round of this year's "stress test".

Didn't the bank just pass the stress test?Well, yes... but this was just one part of it. The Federal Reserve released the results of the first round of stress tests, and for the first time, every single bank tested passed.

Basically, the first round of testing is a preliminary measurement of how well the banks would be able to withstand "severely adverse" economic conditions. For the purposes of these tests, the most extreme hypothetical scenario includes a 10% unemployment rate, a 25% drop in home values, a 60% plunge in the stock markets, and oil prices rocketing to $110 a barrel.

Under this scenario, which is unlikely to materialize -- after all, that's the point of a worst-case scenario -- Citigroup passed with flying colors. At the low point of this hypothetical recession, Citigroup's Tier 1 common capital ratio would fall to 8.2%, well above the minimum of 5%, and the company's Tier 1 leverage ratio would drop to 4.6%, exceeding the 4% minimum required by regulators.

However, Citigroup got past the first round of stress tests last year, too. The second round involves the Fed's approval or disapproval of the bank's capital plan, including any plans to increase the dividend or to buy back shares. Citigroup is the only one of the big banks to have failed this portion twice, in 2012 and 2014.

The stress test can give shareholders something they haven't had in yearsWhen the final stress test results are released on Wednesday, many experts are expecting Citigroup's capital plan to receive the Fed's approval. This would likely mean a long-awaited increase to the stock's dividend, which hasn't been more than $0.01 per share per quarter since 2009.

Even though the most likely dividend increase to $0.05 per share would produce a paltry 0.4% annual yield, it could do wonders for the market's confidence in Citigroup. And for shareholders, it would be a big step back toward Citigroup being a legitimate long-term investment, and not just "the riskiest of the big banks."

It's also worth noting that if Citigroup's capital plan gets rejected, shares could pull back a bit. I don't see this as a very likely scenario given the strength of its capital ratios; but it's certainly possible.

Whatever the outcome this week, things aren't going to change overnight. Citigroup still has substantial exposure to emerging markets that creates a lot of uncertainly, and the $98 billion worth of assets still in Citi Holdings is likely to continue to weigh on the bank's bottom line.

However, as the issues facing Citigroup -- including passing the stress tests -- continue to work themselves out, we should see the valuation of Citigroup's shares gradually rise. And at a 20% discount to book value, there's certainly a lot of room for that to happen.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool owns shares of Citigroup and owns and recommends shares of Apple and Bank of America. 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.

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