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Goldman Sachs (NYSE:GS) is one of the few companies in the banking industry that I trust over a long-term horizon. Often known for hiring the smartest and most motivated people from around the world, Goldman operates in four broad categories: investment banking, institutional client services, investing and lending, and asset management. Before the 2008 financial crisis, Goldman saw return-on-equity numbers around 25%. Those days are now over after the Dodd-Frank Wall Street Reform and Consumer Protection Act placed heavy regulation measures on capital structure, trading and investing activities. However, Goldman is still one of the best at creating profits, and it has done so very well even after regulation. While other U.S. and even European banks have struggled to restructure their businesses, Goldman did not have those problems. It can no longer take on extremely risky bets, but it can still realize above-average returns with moderate risk in this new environment.

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Goldman has outperformed the S&P 500 by about 6% since the beginning of the year. As you can see, the firm had increased in value by as much as 30% back in early June, but Chairman of the Federal Reserve Ben Bernanke's comments about its $85 billion-a-month bond buying program rattled Goldman's stock. This may be due to the fact that interest rates rose sharply, narrowing Goldman's net interest income. Regardless, the stock has performed very well in the first half of the year, and I expect this trend to continue.

Now that I have given you a brief introduction about Goldman, let's take a closer look at why I believe the company is a great investment.

Growth

As I mentioned earlier, relative to Goldman, many major banks experienced heavy losses during the financial crisis, allowing Goldman to take advantage and increase market share. Goldman still suffered and even paid a fine for misleading investors in its mortgage-backed securities business, but it did not suffer as much as the others. Earnings have grown faster than revenues since 2011, suggesting that the firm is operating more efficiently and controlling costs.

20122013E2014E
Revenue$ 34.1B$ 34.1B$ 34.8B
EPS$ 14.13$ 14.40$ $15.18

Revenues will start to grow steadily as the firm becomes more dependent on how it operates in the new regulatory environment rather than on the cycles of the economy. Earnings are expected to surpass $15 per share in 2014, and analysts expect this trend to continue going forward.

Additionally, Goldman has been increasing its dividends. Investors do not consider this company to be a dividend machine, but dividends per share have grown over time. Dividends grew by 29.8% over the past year, and they have grown by an average of 7% over the past 5 years. Although one can make the argument that increasing dividends is a sign that a company cannot find new ways to use its cash, I believe that this is a sign of confidence. Goldman's executives are very positive about the firm's outlook, and therefore they can afford to reward its shareholders.

Company Comparable Analysis

Now that you have an idea about Goldman's growth prospects, let's take a look at how it compares to its rivals. I have used Morgan Stanley (NYSE:MS), JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC), and the financials sector (NYSEARCA:XLF) as benchmarks to compare to Goldman.

Market CapP/EROEDividend Yield
GS$ 72.34B10.5110.61%1.25%
MS$ 48.04B16.241.53%0.80%
JPM$ 199.87B9.0611.32%2.26%
BAC$ 139.17B13.681.64%0.31%
Industry$ 80.84B14.377.60%1.88%

Goldman ranks below the industry average in market cap. However, Goldman focuses mainly on investment banking and trading activities, while some of the other giant banks have enormous commercial banking and mortgage businesses. I interpret this as Goldman having its own identity and focus as a banking and trading firm.

Goldman looks cheap on a valuation basis. Its P/E ratio is well below the industry average, and it also delivers an impressive return on equity. Therefore, Goldman does a fantastic job at returning wealth to shareholders relative to its peers even during a new regulatory environment.

Finally, Goldman ranks below average in dividend yield. However, as I mentioned earlier, Goldman has increased its dividend steadily over time, and I believe that this is a function of the executives' confidence in their own company.

Valuation and Target Price

I believe that Goldman is intrinsically worth more than its current price of $151.25 per share. Goldman is currently trading at an 18% discount on an equity relative value basis. On a two-year historical average basis, Goldman has traded at about a 12% discount. This means that the firm is currently cheaper than usual. Taking an 18% discount on the current industry P/E, we arrive at a FY1 P/E of 11.78.

FY1 P/E Implied Multiple = (1-.18) * 14.37 = 11.78.

Applying Goldman's 2013 estimated EPS of $14.40, Goldman is worth $169.98.

Target Price = 11.78 * $14.40 = $169.98.

This represents a current upside potential of 12.38%. Considering that analysts expect EPS to increase steadily, I believe that Goldman will eventually become worth much more over the long term.

Risks

As with all companies, Goldman carries several risks that need to be considered in order to make a sound investment decision. After the 2010 regulation measures were put into place, Goldman became a "systemically important financial institution." This has two consequences. First, people will become more critical of Goldman's operations. And second, the government has the right to take action against the firm if it becomes a threat to the stability of the financial markets.

Additionally, Goldman is still highly leveraged. Before 2008, the bank had a gross leverage ratio of about 25 times. Analysts expect this figure to normalize to around 16 times. This amount of borrowing means that Goldman relies on its creditors for funds. Short-term funding is not as much of a concern anymore since the firm now has access to the discount window, but the firm still carries default risk. Investors should be aware of the leverage risks inherent in the banking industry.

Conclusion

Regardless of these risks, I believe that Goldman is an outstanding investment for the long term. The firm constantly brings in new talent, develops its new hires properly into brilliant minds, and has an unmatched understanding of the capital markets and trading businesses. Goldman takes a very disciplined approach to its businesses.

Very few banks can rely on its brand recognition to bring in revenues. Goldman is one of those companies in the eyes of institutional investors across the globe. Its international scope and ability to bring in new deals give it a major competitive advantage over smaller banks and even some of the larger ones. The asset management business enjoys this advantage as well, as investors will start to trust Goldman with their money.

Goldman presents a wonderful investment opportunity in the financials sector and for those in it for the long run. It is cheap on a valuation basis and does a great job at returning value to its shareholders.

Source: Goldman Sachs Is An Outstanding Investment