Goldman Sachs (GS) continues to do a phenomenal job creating shareholder value. The stock has recently topped out at $220 per share which translates to over a 50% gain in just 12 months. With GS currently trading at 10.5 times its next year's earnings (industry average is 18), the stock would appear to show that it may be “undervalued." But is that really a fair assessment? Let’s review the pros and cons of GS:
The case for GS
Goldman does a very fine job managing its balance sheet. They have grown shareholder equity from $10.1B in 1999 to $35.8B in 2006, resulting in a compounded average growth rate of 20% on a year-to-year basis. Much of this balance sheet strength comes in the ability to not only grow revenues at an aggressive clip but also manage their margins in a prudent manner. From a net revenue standpoint, the firm earned over $37.7B which was a 49% change on a year-to-year basis. They have also seen their pre-tax margins increase from 23.3% in 2002 to 38.7% in 2006. The firm’s return on equity is an amazing 32.8%. And the stock continues to show strength on reasonably consistent volume with a year-to-date performance of 10.43%.
The case against GS
Two words to describe the GS earnings model: “potentially unsustainable.” Investors should really ask themselves, can the firm really continue to basically print cash at such a rapid clip? And is the stock price currently pricing in an expected, above-average growth rate. I am not so sure that this is possible. If you back out the one-time Chinese ICBC deal, which netted the firm almost $1B in revenue, then the earnings are not nearly as strong. Further, can the trading desk continue to pound out returns as they have recently with interest rates and alternative investments paving the way to outsized profits in their proprietary portfolio? Again, I would say we are not so sure. In fact, a recent Bloomberg article discussed problems that GS is having with its largest hedge fund, Global Alpha, which actually finished 2006 in negative territory.
Quantitatively, the firm continues to add revenue at the cost of increasing the firm’s risk. Their VAR (value-at-risk) metric continues to increase significantly every quarter and, at some point, I believe the firm will have to realize that their appetite for risk is probably not worth the expected return. As a result, critics might suggest to expect a 2Q07 slowdown in FICC and portfolio management returns.
Conclusion
I am currently a holder of Goldman Sachs. Recent highs in the stock price have prompted me to prudently re-evaluate the stock. Will it move higher or lower? Does the “case for” GS provide enough equity to fuel much higher valuations? Perhaps the one element of GS that cannot be measured but is at the very heart of the firm is their “intellectual capital.” The firm is compromised of some of Wall Street’s finest and smartest bankers, traders and dealmakers that understand how to run a business. Simply put, they may be too smart to not let the stock move higher. I think I know what side I am on...
Disclosure: Author is long GS
