Something must happen to Goldman's stock
While evaluating an investment, the first rough result obtained without too many external inputs can be very different from the value assigned by the market. That often means we did not include some critical assumptions in our calculation and it will likely be corrected by following iterations. However, sometimes the majority of the gap stays even after several reviews, and that is an indication we might be onto something. In similar situations, we should ask ourselves the possible reasons behind our result. The activity could reveal some opportunities. It happened to me lately. After I went through a round of evaluation of Goldman Sachs as a business and investment, I got that strange feeling of having a potentially different view of the company compared to the market. In the past, I experienced a similar feeling a few times, and I regretted not having examined the situation further – there is the argument that the stock market is indeed efficient in the long term, while still presenting opportunities in the short one.
Please note, this post will not focus on investment recommendation, something which we will not provide here - we cannot and we do not want. While framed in terms of financial valuation, the concepts below are believed to be strategic inputs valid from business analysis to business management; that is the reason for this article.
Let us discuss Goldman Sachs' recent performance
Having some long-term equity positions in Goldman Sachs, I decided to go through a round of re-evaluation of my investment after the latest earnings release of the company on October 15th, 2021 (Q3 2021). Let us dive into the specifics and summarize the view in three points – the reader can additionally reference the original document here.
Also, the interested person can go on our erreVol.com; something we have leveraged for this post, a tool providing strategic natural language processed summaries (NLP) from the transcripts of listed companies' earnings calls – more on that at the end of the post.
1 - So far in 2021, GS has had excellent results in revenues; even more so in earnings
The latest sales of the company are $58+ billion on a trailing twelve months basis (TTM) from last year’s Q4 to this year’s Q3. That represents a +32% year over year (YoY) increase compared to the full year (FY) 2020 of $44+ billion, which in turn was a YoY increase of +22% compared to the FY 2019 of $36+ billion. What is probably more interesting is the view on earnings to common shareholders. For the three periods mentioned above, they are respectively slightly shorts of $22 billion, $9 billion, and $8 billion. To conclude, while the growth in sales during 2021 is in line with the excellent growth already experience from 2019 to 2020, it is the growth in common earnings of 2021 to probably represent a more than excellent jump of about x2.4 ($22 billion vs $9 billion).
Simplifying a bit for sake of this writing, similar phenomena happen when the operating leverage and the cost structure are such that variable costs are contained as a percentage of sales and fixed costs have been already covered by sales. Beyond that point, profitability quickly jumps because new sales need to cover only limited variable costs and the rest is all pre-tax profit – readers can think in terms of “break-even analysis”, something any entrepreneur or manager should know about their business. The critical point to note is that when we are crossing that break-even point, slightly losing part of the revenues recently gained can bring us back to much lower earnings – not just slightly so – unless we plan and execute a deep restructuring of the costs. Conversely, if we plan to increase revenues even further, those costs might be deemed even conservative.
2 - Goldman Sachs’ stock appreciated about +70% year-to-date (YTD) in 2021. Still, Goldman’s valuation seems fairly attractive at first [quantitative] glance
We will use a simple metric [probably too simple] to measure how the market is pricing Goldman, that metric is price over earnings (PE ratio) – intended to be just a summary of a more complete model like discounted cash flows (DCF). The stocks of banks and financial institutions do not usually present high multiples. It is not unusual in recent years to have multiples in that industry contained between 6 and 12 – as a comparison, tech stocks usually have PE = 30+. Reasons for that range of PEs are several, but a lot could be related to the difficulty of forecasting growth in sales, the difficulty of evaluating all the financial assets and liabilities on the balance sheet, and even to the limited growth potential sometimes assigned to the financial industry. That may be in part confirmed by the fact that banks and their peers usually pay good dividends, apparently not having better investment opportunities than returning money to shareholders – when not repurchasing their own shares, as per our post on the hidden math of share repurchasing.
However, especially at current times of volatile rates and high mergers & acquisitions (M&A) or initial public offering (IPO) activity, institutions like Goldman Sachs sometimes do show volatile performances. Moreover, low PEs can play an important role at times where there seems to be pressure on valuations from possible rising rates, similar to what we may be currently experiencing. Sometimes, at those moments, stocks more heavily affected are the ones with higher ratios and longer "duration" like technology stocks – "duration" meaning: because of the underlying discounting math, valuations relying more heavily on long-term growth and cash flows far away in the future would be affected the most by rising rates and rising discounting rates. At the moment, while investors are pricing on average the NASDAQ at 30 times its earnings, therefore asking the market about 3% return on the investment, Goldman Sachs is trading at about 6 times its latest earnings of $22 billion (current market cap $128 billion), which means investors are requiring Goldman to return them about 16.5% annually. It is interesting to note that Goldman’s PE based on the last full-year earnings (FY 2020 at $9 billion earnings as reported above) would be about 14. Therefore, considering the usual range of the financial industry, between 6 and 12, the valuation of the company may be deemed low or high (say also in line with other major financial institutions) based on the investors’ view on the level of earnings representing Goldman's long-term potential. So, a critical question to answer would be: is the current earnings’ level of $22 billion just an accidental number composed of one-off positive effects, or it is indeed an organic improvement meant to stay?
3 - Whereas we just examined the good performance of the income statement and the opportunity it could represent considering the value of the valuation, Goldman shows some red flags which are better examined through the balance sheet
When it comes to financial institutions, income statement and balance sheet are particularly related, and that is what we will discuss here. Goldman's income statement presents different types of revenues: on one hand organic sales like investment banking fees (e.g. M&A and IPOs services) or wealth management fees from managing clients’ money, on the other hand, revenues or expenses with a more “accidental” character, like the ones due to periodic re-evaluation of financial assets and liabilities on the balance sheet. While the discussion is quite technical – in part described also in another post of ours linked here and related to Principal Financials Holdings (PFG) and KKR Inc (KKR) – any company would re-evaluate periodically assets and liabilities at fair value in case material changes applied - fair value is not the only option. Those adjustments would then determine gains or losses in the income statements, and they could either continue or revert in the future like for example in the case of equity participation in another public company. Because of the nature of their on-balance-sheet holdings, fair-value adjustments are very common at financial institutions. Let us look at the line of revenues on Goldman’s income statement called Other Principal Transactions, which in the first nine months of 2021 increased from $2.5 billion to $9.7 billion, making for about half the total increase in revenues of the period - the investment banking business makes then for the majority of the remaining increase jumping from $6.4 billion in 2020 to $10.5 billion in 2021. We could argue that those revenues are mostly “accidental” because mainly due to changes in the estimated value of assets and liabilities on the balance sheet. It could be argued that those revenues cannot be considered organic, and they are more likely to be one-off positive contributions possibly related to the current financial environment involving interest rates, general market trend, etc.
Here is an example of what is included in Other Financial Transactions: in the first nine months of 2021 Goldman recorded in that account about $1.8 billion of revenues obtained by up-valuating at fair value the investments it holds in other equity securities, compared to a total adjustment of about $280 million in the same period of 2020. Most of that could be related to the rising equity market experienced during the period (the S&P increased +27% this year). An investor thinking that the equity market was unlikely to experience in 2022 a similar run of 2021 would likely reduce the forecast for Goldman’s performance in 2022 by something like $1.5 billion. This is just a simplified example. The critical point is the following: we are not saying that anything contained in accounts like Other Financial Transactions should be immediately ignored in our calculation, but we are saying that we should carefully think at what would be a normalized value for those accounts that we could incorporate in our long-term financial model.
Some additional notes
Before leveraging the three main points above for closing this post with our strategic view on Goldman Sachs, a couple of additional considerations an investor might want to pay attention to:
Other major accounts of the balance sheet potentially affecting the valuation: Goldman has accounts like the cash balance and the long-term unsecured debt that are fairly stable during the year, meaning that they are constant at least as a percentage of sales. Therefore, while they do affect the valuation – the former positively and the latter negatively – they are unlikely to result as the determinants of possible different views on valuation.
Other revenue-lines containing part of the adjustments not included in Other Financial Transactions: some of the fair value adjustments that Goldman Sachs made during the period are not included in Other Principal Transactions but are included in the line of revenues called Market Making - this is because those adjustments apply to financial assets held for the market-making activity (please ignore if not familiar with market-making). This is true for example for part of the change in fair value associated with derivative products, which for the first three quarters of 2021 was in total about $107 million and was split almost equally between Other Principal Transactions and Market Making.
Litigation expense: while earnings of Goldman seem to have benefited so far in 2021 from limited variable costs and stable fixed ones, in 2019 GS had about $3.4 billion in litigation expenses on total costs of about $29 billion. So far this year Goldman has not posted any expenses related to litigation, something providing an additional benefit. Ongoing procedures involving Goldman do exist and are included in the notes of the financial release from the company. Those procedures could potentially impact future statements, even the one soon due at year-end 2021 (Q4 and FY 2021).
Year-end adjustments and full-year 2021: While the latest results from Q3 2021 are already indicative of the different performances of 2021 from 2020, investors should keep in mind that the performances of 2021 are still missing Q4 2021, to be released in a few months. Year-end quarters can sometimes present adjustments for the whole year which would more heavily impact the overall result. Therefore, FY 2021 performances could go back towards levels more similar to historical ones. In our previous post mentioned above, we somehow misjudged KKR Inc (another type of financial institution) because of similar phenomena (post and details linked again here).
Conclusion
According to the numbers discussed above, we could summarize the following:
Goldman Sachs has had good performances so far in 2021. Moreover, because of the structure of the costs of the company, earnings have jumped – earnings are the ultimate value to an investor.
Goldman Sachs presents a valuation that may be thought as being either in line with the industry if we considered the last full-year earnings from Q4 2020 (PE equal to 14), or that could be considered attractive based on the latest trailing twelve months’ value (PE equal to 6) - the two PEs are very close to the opposite ends of the PE range for the industry.
Picturing an investor evaluating a possible position in Goldman based on the two considerations above, a lot of the final decision is likely to hinge on whether Goldman’s recent results are deemed mostly one-off adjustments and unlikely to stay, or whether a lot of the company’s increased performances are considered organic and likely to stay. Please note, it could also be possible to think that a lot of the adjustments we discussed are indeed one-off contribution, but then also forecast a more than offsetting organic growth within other revenue lines like the Investment Banking one. In fact, we want to stress that we are not promoting here any bullish nor bearish argument; we just want to provide strategic and quantitative insights.
Since the current PE ratio could be deemed to be at either one of the two opposite ends of the usual range of the specific industry, and since long-term performances could verify both values as well, investors might be proven either right or at the opposite end of the valuation. Of course, there is also the option of a milder transition towards more intermediate levels, or even towards values beyond one of the two boundaries. The interesting point is that with such a broad gap, any movement is likely to be meaningful to those positioned at one of the extremes.
As per other posts, we will likely return to Goldman Sachs in a few quarters to check how events will have unfolded. As it happened for another post of ours on a few business cases first discussed and then checked after about one year against the real events, we may have a partial confirmation or disproof, anyway, we will likely learn something.
Important disclaimer: this post does not represent in any ways investment advice. I personally hold positions in Goldman Sachs' equity.
In case the reader wanted to help on erreVol.com, here are additional information:
At the section of the website called “Company Insights” erreVol provides a tool processing the transcripts from recent calls of earnings releases of US-listed public corporations. ErreVol uses natural language processing techniques (NLP) to find and report only relevant passages, providing structure and relevance to the unstructured transcript. While not a fixed metric, the summary is usually about 20% in length compared to the original transcript, saving time to the user by providing only relevant passages. Moreover, the summary can be customized by specifying a particular topic of interest. ErreVol performs the same activity on recent news related to the specified company.
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Tag of the original picture used for following customization with Goldman Sachs' logo: