Goldman Sachs: Less Risky, Less Profitable?
Board: Value Hounds
I like to do writeups of the companies in my personal watchlist of about 30 companies as part of the research. It helps to organize thoughts when I write down how a business works and why it may or may not be a good deal. Posting it to the boards catches mistakes. :)
Joe Magyer did a nice writeup of Goldman Sachs as an investment idea for the TMF Inside Value newsletter, where he's senior adviser. That got me interested enough to investigate the company myself. Here's my own writeup:
Goldman Sachs was founded 143 years ago in 1869 by German immigrant Marcus Goldman. Goldman's son-in-law Samuel Sachs joined the firm in 1882. The company helped pioneer the use of commercial paper as a source of funding for companies and joined the New York Stock Exchange in 1896. In the early 20th century Goldman Sachs established itself as a major player in the IPO market, facilitating some of the biggest IPO's of the time, including Sears, Roebuck and Company in 1906.
Goldman Sachs didn't become a publicly-traded company itself until 1999, offering up 52% of its shares while retaining the other half for its partnership pool. These days though about 86% of the shares are publicly owned and available for trading.
Goldman went through another major change during the 2008/2009 credit crisis when it and Morgan Stanley, the last two standing major investment banks, converted themselves into bank holding companies. Times were pretty scary then and liquidity was difficult to find. If you're levered 25-to-1 and run into liquidity problems you're in very big trouble. If you look at Goldman's balance sheet you'll notice that most of its liabilities are short term, consisting of payables to customers, repurchase agreements for treasuries it sold, etc. While in normal times this is not an issue, if you're levered 25-to-1 and all your customers freak out all at once and want to get paid NOW, you have a problem, especially if only 12% of your assets are highly liquid (held as cash or treasuries), your receivables are not immediately recoverable, and the rest of your assets are held in things that have, at least for the moment, stopped trading. Converting to a bank holding company gave Goldman access to the Fed discount window as a funding vehicle just like any other bank holding company. Access to the discount window guarantees liquidity even in the middle of a financial crisis even when all other doors shut.
The downside to converting is that Goldman Sachs is now subject to the same sort of leverage and capital ratio requirements as a bank like Wells Fargo is held to. The days of 25-to-1 leverage on equity and the accompanying stratospheric 25%+ returns on equity (though done at high risk) are now gone. Currently Goldman is levered about 13-to-1. Goldman's bank ratios (Tier 1/Tier 2 Capital, leverage ratio) are all in very good shape, even when looked at using the new, more strict Basel III standards.
So what we have now is a safer company (less leverage, guaranteed liquidity) earning lower returns on equity (due to that same reduction in leverage). It's a different company than it was just a few years ago.
Goldman Sachs' business is split into four divisions:
Institutional Client Services (60% of 2011 revenue): the bulk of revenue is made in this division. Most of this revenue is made through market making services, where Goldman acts as the middle man, matching up buyers and sellers of various securities, making money on each transaction through the spread in price it buys and sells the securities for. The range of securities Goldman covers here runs the gamut: stocks, bonds, options, futures, commodities, and currencies. Goldman also makes money in this division by lending money to clients through margin loans, collateralized by the client's assets.
Investment Management (18% of 2011 revenue): this is the division that offers asset management services to institutions and high net worth individuals. Fees are charged for various services, ex. managing money, issuing loans, trust and estate planning, tax planning, etc.
Investment Banking (15% of 2011 revenue): though making up only 15% of revenue in 2011, this is the division where IPO underwriting, m&a advisory services, and debt underwriting occur, the very services that are most popularly associated with Goldman. The amount of revenue made in this division is pretty volatile, since some years are heavy with IPO activity and some years are very sparse.
Investing and Lending (7% of 2011 revenue): this is the division that makes longer term investments with the company's asset base. For example, Goldman's investment in the ordinary shares of ICBC, the largest bank in China, is housed here. This division makes equity and debt investments in corporations, real estate, and infrastructure.
So what's it worth? Like any big financial firm, it's not all that useful trying to do the traditional estimate of free cash flow. Why? Two big reasons. The first is that financial firms are very cyclical (due to the combination of economic cycles and extreme leverage). Earnings swing wide year to year. The other reason is that the classic accounting distortions that occur in a typical firm's earnings when compared to actual cash flows don't tend to happen in a financial firm. A financial firm, even a large one, tends not to have to spend large amounts of money on capital expenditures to keep the business going and so doesn't have much in the way of depreciation and amortization either.
The way I like to value a financial firm is instead to look at a very long term (ex. 10 years) view of return on equity. I look at that return history as a starting point and then use judgment as what a long term future return on equity will look like going forward. I then see what kind of cash I end up with when I apply that return on equity to the equity base, after I take into account any impairments to the equity base that might occur due to bad loans, etc. After that I discount those returns back at the minimum rate of return I want to get to wind up with a present value. Long story short:
1. Look at the equity base, that's what you own as a shareholder. Subtract out from that equity base an estimate for any bad loans that might come back to bite you on top of the loan loss reserve the company has already created.
2. Estimate a return on that equity base going forward. That's the money you'll make on that pile of invested money.
3. Discount that money back to the present at the minimum rate of return you expect (i.e. your discount rate)
The theory is simple, the time-consuming part is wading through all the financials to have an informed opinion and the experience to make a proper judgment call on all three.
The equity base I use pretty much as-is. Goldman has a good history of being prudent with its capital: it's no Bank of America or Citigroup, and hasn't suffered through having to do large asset writedowns, leading either to large equity issuances or government bailouts. Remember that Goldman's use of TARP (now fully paid back with interest) and conversion to a bank holding company was about gaining access to incredible amounts of liquidity and a very nasty time, not because it was facing insolvency (cough, cough, AIG, BAC, C, Merrill Lynch). Goldman Sachs also doesn't have the large lawsuit overhang that BAC does, where damages and fines have to be roughly estimated for bad mortgages sold.
About 60% of Goldman's assets consist of cash, cash equivalents, and short term borrowings and loans to other financial institutions (usually involving treasuries or other ultra-safe short term securities). No problem there (as long as there is liquidity in the market!)
About 40% of Goldman's financial assets ($385.5 billion out of $951 billion) are held in the opaquely-entitled "financial instruments owned" category. About half of this is held in very safe short term assets such as CD's, money markets, treasuries, and non-US government bonds. Most of the rest is held in corporate debt securities, municipal bonds, and equities, both public and private. This is partly a black box section. Though Goldman lists the types of securities owned it doesn't list what's owned within each category in any detail (nor does any other bank). You have to take it somewhat on faith that the money is being invested prudently and know that every quarter almost all of the financial asset portfolio is revalued using market prices. Only 4.8% ($46 billion) are level III assets, which are assets that are difficult to easily price since they aren't publicly traded (Level I) or very similar versions of them aren't publicly traded (level II). You can see here where leverage can get you. With only $71.6 billion in equity vs. $951 billion in assets, small screwups relative to assets can be a big hit to equity.
GS does have $5.2 billion in net exposure ("net" meaning after hedging) to the PIIGS countries though 68% of this is to Italy, the safest of the PIIGS. Still, I'm going to write off 40% of this, punishing equity by $2.1 billion. That takes the equity base down to $69.6 billion. GS doesn't have a loan loss reserve line item in the classical sense that a normal bank like BAC or WFC does. Most of the money GS makes (82%) is from spreads on securities it make markets for and from fees it charges, not traditional loans.
What return on equity should we use? Goldman's 10 year average is 17% but Goldman is a different company now, beholden to bank holding company regulations. This prevents the extreme 25-to-1 leverage that helped produce the super high ROE's of the past. Now that Goldman is levered a relatively more conservative 13-to-1, ROE's likely will be more in the low double digit range. Last quarter's ROE was 12.2% for example. In my valuation I'm going with what I think is a conservative 11.5% ROE.
For point of comparison, BAC's 10 year average ROE is 11.8% and WFC's 10 year average ROE is 14.8%. All of these companies though will experience lower ROE's going forward since the new Basel III standards require holding more capital. When you have to hold more capital you can't lever up as much. In my Bank of America (BAC) valuation I'm using a 10% average ROE going forward and for Wells Fargo (WFC) I'm using 12.5%. So that puts my 11.5% ROE I'm using for Goldman in the middle between BAC and WFC. I think that's conservative and I think there's a good chance Goldman could at least match WFC.
I'm discounting the cash flows back by 10%. While some may say this is too low for a firm like Goldman Sachs I've already penalized the equity base with a substantially large PIIGS writedown and have chosen what I think is a conservative return on equity. Therefore I'm discounting back at a middle-of-the-road 10%.
Using these assumptions I end up with a fair value estimate of around $189 a share. If I boost the discount rate from 10% to 11% my fair value drops to $148. At 12% the value drops to $117.
Morningstar puts the value of the shares at around $147 but use a 12% cost of equity. Conversely though, Morningstar thinks GS can achieve roughly a 13% ROE, so they're more conservative on the discount rate and less so on the ROE than I am.
TMF IV estimates the shares at around $175, basing part of the valuation at a return to a price to tangible book value ratio of around 1.14 (the historical long term average) vs. the ~0.81 it's trading at now.
Valueline's 3-5 year target is between $170 and $255: if I take the average of the two numbers and discount back by 10% for 4 years I get $145.
I'm on the high side of all these, chiefly due to my cost of equity likely being on the low side at 10%. That said, I don't view GS having the same types of risks it used to have and I think a 12% cost of equity is punitive relative to the new risk profile.