Shares of Goldman Sachs (GS) are rising modestly this morning, to about $98 each, after the investment banking giant beat earnings estimates for the fourth quarter. Earnings for 2011 came in at $7.46 per share, down about 50% versus last year, as the business has been struggling through a cyclical industry downturn. Still, the company made a $4 billion profit, bought back about 8% of its shares outstanding, and grew book value by 1% in 2011. And yet, the stock is trading about 20% below tangible book value of $120 per share.
I have been making this argument for a while, and holding the stock has not been fun while it has been treading water far below tangible book, but even with a cyclical industry like investment banking, GS stock should not be at these levels. It is really hard to see how the company would face a scenario where book value dropped 20% from here (which is essentially what investors are fearing when the stock trades at $98). If the sub-prime mortgage meltdown barely hit book value at Goldman, I don’t see the European debt crisis doing far more damage. And even if the industry does not turn around as quickly as it has in past cycles, book value will likely go sideways or slightly higher, as we saw in 2011.
For investors to justify the idea that large, well-positioned, and profitable financial institutions should be trading far below tangible book value per share (and GS is far from the only one), one of two scenarios would need to play out. First, the companies would have to have huge unrealized losses already sitting on their books, which when realized would crush book value and wipe out the discount on the shares. Unlikely. Second, the business model would have to break down long term, rendering the firms unprofitable, which would result in a slow degradation of book value (again, narrowing the valuation gap to the downside). Again, unlikely.
Profit margins will likely drop permanently due to the Volcker Rule (no prop trading), but they should stay in positive territory (Goldman’s ROE in 2011 was 6%). That should result in lower price-to-book valuations for these banks versus prior cycles, but not below one. As a result, I think GS and their strong peers should trade for at least tangible book value, which means about 25% upside from here.
Full Disclosure: Long Goldman Sachs at the time of writing, but positions may change at any time