Despite Recent Rise, Goldman Sachs Still Fetches Single Digit P/E

In recent weeks I have been accumulating shares of Goldman Sachs (GS) for my clients, more so now than any other time since I began managing money. In a market environment where over the course of a single year most stocks have gone from severely undervalued to fairly valued, it remains pretty easy to make the case that Goldman stock is undervalued, despite a $20 increase just recently.

Why is the stock still cheap? No doubt due to the negative press coming from both political and consumer circles. Somehow Goldman Sachs is being made out to be a bigger problem for our financial services economy than sub-prime mortgage lenders and insurance companies that chose to insure everything on the planet without ever setting aside any money to pay future claims. Goldman Sachs never gave out mortgages like candy on Halloween and although they did benefit from the AIG bailout (their claims were paid out 100 cents on the dollar after the government bailout) people should be mad at AIG and the government long before blaming Goldman Sachs for owning insurance policies.

The investment case for Goldman stock, however, does not really involve a political or moral viewpoint (many of us will disagree on those points anyway). The real issue from an investor standpoint is that Goldman is the best of breed investment bank in the world ( this was one of the key takeaways from the credit crisis, in my view anyway), has seen many of its competitors go out of business or dramatically scale back operations, and yet at around $170 per share the stock still trades for less than 10 times estimated 2010 earnings.

Why do I think such a valuation is too meager? Well, all we have to do is rewind the clock back to before the credit crisis and recall what the investment banking landscape looked like. Back when the Big 5 investment banks were still in existence (Goldman, Morgan, Merrill, Bear, and Lehman) there was often a valuation discrepancy. It is actually very interesting to revisit how these stocks used to be valued by the market. Ever since it finally went public back in 1999, Goldman typically fetched a premium to the group (they have always been seen as the cream of the crop). Morgan Stanley and Merrill Lynch were very diversified and strong global franchises, and therefore were close runners up while Bear Stearns and Lehman Brothers were generally seen as less attractive, mainly due to an over-reliance on fixed income businesses for their revenues. They typically traded at a discount to Morgan and Merrill (about 10 times earnings versus 12 times) while Goldman often commanded a premium (15 times earnings or more).

This is interesting, of course, because the credit crisis essentially proved that the market was very accurate in its evaluation of the five large investment banking institutions. Bear and Lehman collapsed thanks to their heavy concentration in fixed income (many of those bonds and securities were backed by mortgages). Merrill Lynch and Morgan Stanley were on the brink but managed to find partners to help them back (Bank of America bought Merrill and Morgan got a large investment from overseas). Goldman, meanwhile, came through the credit crisis relatively unscathed (and would have been okay even if they had only gotten 80 or 90 cents on the dollar for their AIG contracts). For the most part, the market got it right.

Fast forward to today. We know that Lehman and Bear were the worst of breed and that Goldman is still tops. And yet Goldman Sachs stock today trades at a lower valuation than Bear Stearns and Lehman did pre-crisis. How does that make any sense? Has the credit crisis not proved that Goldman traded at a premium for good reason?

Going forward, I believe the valuation range we will see for investment banks will continue to be 10 to 15 times earnings. Maybe the lower end of the range is more likely near term as investors worry about political and consumer backlash. Maybe Morgan Stanley fetches a 10 P/E instead of 12 times, but Goldman should still command a premium to reflect their investment banking franchise. Granted, maybe that premium is only 12 times earnings.

Still, from my perch buying Goldman stock at less than 10 times earnings is a tremendously attractive risk-reward opportunity. The only way such an investment comes back to bite anyone is if either, one,  the P/E drops significantly below 10, or two, Goldman’s earnings have peaked and will trend lower in coming years. Frankly, I see both of those possibilities as extremely remote, especially longer term. Instead, I think Goldman Sachs should be able to earn around $20 per share and after the policy fallout has passed longer term, the P/E ratio should rise to 12 or higher. In that scenario, Goldman shares would fetch $240 each, or about 40% above current levels.

Full Disclosure: Clients of Peridot Capital were long shares of Goldman Sachs at the time of writing, but positions may change at any time

Enjoy this post? Subscribe and never miss another one: RSS | Email | Twitter

9 Thoughts on “Despite Recent Rise, Goldman Sachs Still Fetches Single Digit P/E

  1. Tariq on March 15, 2010 at 4:44 PM said:

    I like your analysis and I think you generally make a very good point.

    The one thing I’d note, however, is that some of the concern regarding Goldman Sachs may come not from broad regulatory/political issues but rather a specific one: the Volcker Rule. To the extent that such a rule limits proprietary trading for all large financial institutions (it is apparently set to include Goldman), then it could to disproportionate damage to GS given their heavy trading profits.

  2. Chad Brand on March 15, 2010 at 5:10 PM said:

    @Tariq- You are definitely correct. I guess I just really don’t expect a material impact. One of Volcker’s biggest complaints is that banks with customer deposits are also engaged in prop trading (or at least separate them). Given that GS is not a deposit gathering institution, I am not really concerned.

    There are rules that could impact them more, such as instituting position limits and/or increasing margin requirements for certain trading vehicles (like CDS and derivatives). This potentially limits what their trading desks could do, as well as their trading clients from whom they earn commissions and fees, but I doubt it would dramatic. In fact, since I think those kinds of rules would benefit the stability of the financial system greatly, one could make the case that even if earnings were impacted 5 or 10 percent, the increased certainty of financial system stability could be a catalyst for higher valuations in the sector as certain worries diminish.

    But yes, you are right that these are the issues overhanging the stock, I simply like the risk-reward at this valuation level even in the face of such issues.

  3. Good stuff Chad. I’d share your sentiment and note that this is the perfect example of taking advantage of short-term mispricings to establish long-term positions. While I still think there are near-term risks that both you and Tariq have touched on, longer term I believe the risk/reward skew is favorable.

    If the market does correct again here soon maybe you’ll have an ideal point to add some more. Out of curiosity have you modeled out a scenario whereby Goldman’s prop trading business is completely wiped out? Just for an “end of days” worst case scenario. Given the regulatory risk, that way you know what’s at stake.

    Thanks as always for your posts.


  4. Chad Brand on March 16, 2010 at 12:59 PM said:

    @Jay- Unfortunately there is no clear way to see exact how much of Goldman’s earnings come from proprietary trading. For instance, they report their equities business split between commissions and trading, but you don’t know how the split goes for trading clients’ money versus trading for their own account. Furthermore, you don’t know if they are putting on equity positions on their own, or if they are pinching pennies from a market making standpoint.

    Lloyd Blankfein pegged their prop trading at 10% of revenue. Others have said it could be as high as 30-40%. My gut would say somewhere in the middle is closer to right, and I would have to think management would be closer to the real number than a third party researcher. At any rate, I don’t think there is any way the government or regulators would prevent them from trading altogether… that is their job after all and it serves a valuable function in the market.

  5. vlscout on March 16, 2010 at 6:29 PM said:

    I think your analysis is grossly incomplete.

    The real question is whether GS’s earnings are sustainable – apparently the market has its doubts.

    Just because they came well through this crisis in part due to their short bets against MBS and CDS protection, does not mean they get it right in the future.

    If anything, with the leverage they play, sooner or later they will take the wrong turn and hit the wall.

  6. Chad,

    Nice article. Your P/E analysis is well done, but with GS (and other financial sector companies), isn’t it desirable to also look at tangible book value? If so, what does that imply for GS?


  7. Chad Brand on March 17, 2010 at 9:05 AM said:

    @Jeff- Absolutely right. Price to tangible book yields a similar conclusion. TBV is about $108 per share right now (~1.6x). A typical normalized range for banks would be 2 to 2.5 times tangible book, or in Goldman’s case $216 to $270 per share.

  8. Chad – Interesting thoughts. Are you concerned that the previous valuations that you reference are based on periods when the banks could take on considerably more leverage, and thus generate higher ROEs? What impact will GS’s becoming a bank holding company have on its ability to leverage returns? Additionally, is the market more volatile today than it was pre-crisis, perhaps justifying a lower multiple?

  9. Chad Brand on March 17, 2010 at 1:26 PM said:

    @Andy- I think the decreased leverage and ROEs are known by the market already and therefore are baked into estimates. GS has already cut leverage in half to 13x and ROE will stay in the low to mid 20’s vs low to mid 30’s during the credit bubble. Volatility has actually come down a lot in recent months, but if it were to increase, that would actually help GS as more trading opportunities mean more money, whether it be for GS’s own trading desk or their hedge fund clients, both of which will in turn help their bottom line.

    I am not trying to argue that GS is without risks, I just think the valuation is more than adequately compensating investors for those risks at only 1.6x tangible book and <10x earnings. Even if I'm wrong and earnings flatline at $15 and the multiple does not rise at all over time, the downside is only about 15%.

Post Navigation