Published on July 9th, 2019 by Josh Arnold
Financial services behemoth Goldman Sachs (GS) is one of the most well-known names in the world when it comes to investment banking. In the 150 years since its founding, it has made itself into a premier global banking franchise.
It is also a member of the prestigious Dow Jones Industrial Average, a group of 30 large U.S. stocks from a variety of industries. You can see the entire list of Dow 30 stocks here.
Goldman’s irregular dividend policy means its consecutive years of dividend increases stands at just eight. In addition, management has made it very clear over the years that the bank prefers to use its excess cash to buy back stock and invest for future growth. Even after eight years of sizable dividend increases, the yield stands at just 1.6% today.
However, the company has robust growth prospects and a relatively cheap valuation. Goldman has a strong plan in place to continue its track record of growth in the coming years, and investors can buy this Dow stock for a reasonable price.
Goldman Sachs was founded in 1869 by Marcus Goldman. Several years later, Marcus’ son-in-law, Samuel Sachs, joined the firm, and Goldman Sachs was born. The firm pioneered the use of commercial paper as a source of funding for businesses, a product that is still widely used today.
Goldman’s history of innovation and going after growth has afforded it a great deal of growth over the years. The stock has a $76 billion market capitalization today.
The bank competes in four segments: Investment Banking, Institutional Client Services, Investing & Lending, and Investment Management.
Goldman reported first-quarter earnings on 4/15/19 and results beat expectations, but earnings fell significantly against last year’s Q1. Total revenue declined 13% from the year-ago period to $8.81 billion, as weakness was present in all operating segments.
Source: Q1 earnings presentation, page 10
Investment Banking’s revenue was flat to the year-ago period, but down 11% against Q4. Financial Advisory revenue was up 51% against last year’s Q1, but down 26% to Q4. Equity Underwriting revenue was down 34% year-over-year and down 14% against Q4. Debt Underwriting was down 18% year-over-year, but up 23% to Q4.
Institutional Client Services revenue was down 18% year-over-year, and was off by half against Q4. FICC revenue was down 11% year-over-year but rebounded 124% against the trough that was set in Q4. Commissions and Fees were down 13% year-over-year and down 11% to Q4. Securities Services was off 14% to last year’s Q1 and 8% against Q4.
Investing & Lending revenue declined 14% year-over-year and was off 4% against Q4. Equity Securities revenue was the main culprit, declining 21% year-over-year, and 15% against Q4. Debt Securities and Loans also fell 7% year-over-year, but was up 9% to Q4’s weak results.
Finally, Investment Management revenue fell 12% to last year’s Q1, and 9% quarter-over-quarter. Management and Fees revenue was down 1% and 2%, respectively, to last year’s Q1 and Q4. Incentive Fees and Transaction revenues also fell sharply, although both of those line items are relatively small. Assets under supervision rose 7% year-over-year, and 4% quarter-over-quarter.
Higher consumer portfolio losses caused provisions for credit losses jump from $44 million in last year’s Q1 to $224 million this year; that number was virtually flat to Q4, however.
Goldman’s efficiency ratio was up 100bps year-over-year to 66.6% of revenue, which is quite high. Management has initiated a comprehensive review process of the bank’s expenses to combat this.
In total, earnings-per-share fell from $6.95 to $5.71 due to dismal revenue performance and rising expenses. However, we note that Goldman’s results tend to be very volatile from quarter to quarter given the cyclical nature of its businesses. As such, one weak – or strong – quarter isn’t necessarily the beginning of a trend change. Indeed, volatility is normal and to be expected for Goldman’s results.
Tangible book value is up to $198.25 per share, which is very near the current share price. This would suggest the stock is very reasonably priced on this measure, as it trades at only a very slight premium to its theoretical liquidation value.
After the weak Q1 report, we’ve lowered our estimate of earnings-per-share for this year to $23.50 from our prior estimate of $24.50.
Goldman’s earnings-per-share has been very volatile in the past decade and for its entire history as a public company. This is due to the highly-cyclical nature of its revenue production, which was shown once again in the first-quarter results.
As an example, earnings only crested 2009 levels last year, as it took the firm nearly a decade to rebuild its shattered earnings. Part of this was due to a much stricter regulatory regime put into place to avoid another liquidity crisis like the one that occurred in 2008/2009, and banks suffered as a result.
However, Goldman’s results will always be volatile, and that is something investors must understand and accept the risk of before owning the stock.
Goldman’s days of struggling to move the needle on earnings have likely ended, and that 8% annual growth will become the norm. The regulatory environment since the Great Recession has been much tougher for banks and investment banks in particular. Regulators have limited the types of activities firms can engage in, in some cases, or in the amount of risk they can take.
Goldman’s historical growth was largely the result of its tolerance for risk, so this was a sizable negative. However, some of that regulation is relaxing, and Goldman stands to benefit.
Source: Q1 earnings presentation, page 7
Goldman also stands poised to grow its revenue using the framework above. Management has a comprehensive plan to attract new clients, expand into ancillary businesses that fit well with legacy segments, and boost its fee revenues over time, among other things.
This includes innovative thinking such as the bank’s relatively new Marcus products, which seek to give the firm access to the “mass affluent” customer, something it has never done before. In addition, the company’s Marquee product is digitizing and modernizing the way money managers see data that is critical for their success. Movement like this, among others, will fuel top line growth for Goldman over time.
Source: Q1 earnings presentation, page 8
Goldman is also in the process of optimizing its spending. The firm is performing a “front-to-back” review, with the “back” portion of that referring to expense optimization. The myriad action items listed above should help Goldman reduce its lofty efficiency ratio and provide some much-needed margin expansion in the years to come.
Indeed, Goldman notes that a 100bps improvement in the efficiency ratio, which is quite achievable, will drive a 40bps return on equity gain. We see the efficiency ratio opportunity as three or four times that level, so there are significant savings to be had should Goldman execute properly; we believe it will.
As mentioned, the dividend hasn’t been a priority for Goldman’s management team, preferring to use excess capital to pay bonuses to employees, buy back stock, and invest in future growth. The payout ratio today is just 15% of earnings, even on the lowered estimate for this year.
We don’t see the payout ratio rising materially in the coming years, but we do see the payout itself continuing to grow modestly. In short, Goldman is not an income stock with its 1.6% yield, and it isn’t much of a dividend growth story, either, given its relatively weak history on the subject. We see this stock as attractive for other reasons.
Valuation & Expected Returns
We see Goldman producing $23.50 in earnings-per-share this year, which would represent a slight reduction against last year’s $25.27 total. This means the stock is trading for 8.8 times our reduced estimate, but that still compares quite favorably to our estimate of fair value at 10.5 times earnings.
As such, we see Goldman shareholders receiving the benefit of a 3.5% tailwind annually to total returns as the valuation reflates to a more normalized level. The stock is very reasonably priced and reduces the risk of further downside in the valuation by buying when the stock is undervalued.
We see total returns at 13.1% annually through 2024, consisting of the 3.5% valuation tailwind, 8% earnings growth, and the 1.6% dividend yield. That puts Goldman towards the front of our coverage universe in terms of expected total returns, the product of a cheap valuation and robust growth prospects. Given this, we rate the stock a buy.
One thing investors must be aware of, however, is that Goldman is particularly susceptible to recessions. Given the nature of its businesses, this is hardly surprising, but the impact can be severe.
Performance during and after the Great Recession can be seen below:
- 2007 earnings-per-share of $24.73
- 2008 earnings-per-share of $4.47 (82% decrease)
- 2009 earnings-per-share of $22.13 (495% increase)
- 2010 earnings-per-share of $14.90 (33% decrease)
- 2011 earnings-per-share of $4.51 (70% decrease)
The volatility in the company’s earnings was extreme, and EPS volatility could spike once again if another recession strikes. On the plus side, the Great Recession provided an outstanding buying opportunity in the stock.
While Goldman Sachs’ results have been volatile over time due to the nature of its businesses, the stock could generate attractive returns going forward.
Goldman’s comprehensive review of revenue generation and expenses should produce a fundamentally better company, with higher profits in the years to come.
In addition, the valuation is quite reasonable, and we see this as an opportune time to consider taking a position in the stock if you don’t expect a major recession ahead.
Investors should keep in mind this is not an income stock, or a dividend growth stock. Goldman will always invest for future growth and in share repurchases instead of cash payouts to shareholders.
Still, for those that can accept the volatility and aren’t expecting a recession in the near future, this Dow stock receives a buy recommendation.