On Monday, a major shakeup of the Dow Jones Industrial Average occurred with Goldman Sachs (NYSE:GS), Nike (NYSE:NKE), and Visa (NYSE:V) entering while Alcoa (NYSE:AA), Bank of America (NYSE:BAC), and Hewlett-Packard (NYSE:HPQ) were shown the door. While Goldman Sachs is now Dow-worthy, is the investment bank worthy of a spot in your portfolio? I believe Goldman's stock has advanced too far and is not an attractive value at current prices.
On the news of its Dow admittance, GS shares rallied a hefty 3.5%, a surprisingly large move consider that very little money is indexed to the Dow compared with the S&P 500. Shares last traded at $165.15, which is a 9% premium to shareholder's book value of $151.21. Given the regulatory burdens on the business, I don't believe Goldman should trade at a premium to book like it has in the past. The company's return on equity since implementation of Dodd-Frank has run at 10-12%. For comparison, prior to the crisis, the company had a return on common equity of more than 35%, hitting 40% in 2006.
Due to proprietary trading restrictions and increased capital requirements, the firm can no longer generate these types of trading profits. In 2007 for instance, GS had EPS of $24.73 on $46 billion in revenue while last year the firm had EPS of $14.13 on $41.6 billion in sales. A 10% drop in revenue has resulted in a 40% drop in EPS. Goldman is now generating a return on assets of less than 1% (0.8% over the past 18 months), and with its leverage ratio far lower, the company simply cannot generate the same type of returns for its equity holders.
When a company's shares trade at book value, your long-term return will be the firm's return on equity. With this new normal of high regulation and lower profits, Goldman can optimistically hit an ROE of 12%. With the stock trading at 1.09x book, the market is calling for an 11% annualized return on Goldman. At first blush, that doesn't seem too bad, but Goldman's profits are very inconsistent. It's the nature of having a trading business. When the firm is wrong, its results will suffer. Given the comparatively risky nature of its cash flows, the market has historically demanded a higher expected return from investment banks. Prior to the crisis when the firm had a higher ROE but traded at roughly 2.25-2.5x book, the expected future return was 15%.
Using this historic 15% benchmark, Goldman shares would trade at 80% of book value or $120. However, we need to recognize that while regulations have limited Goldman's potential profitability, they have lowered the firm's risk profile. By increasing its capital, eliminating riskier trading, and cutting its leverage ratio, a Goldman bankruptcy or liquidation is materially less likely than prior to 2008. With a less risky business model (albeit one that is riskier than most companies), the required rate of return should be less than 15%. I think a 12% discount rate (a 20% reduction for lower risk) is more appropriate, which would suggest Goldman's fair value is its book value of $151.
GS is also over-valued if you prefer to look at the company from a P/E perspective. Because of their riskiness and the fact that trading revenue today does not guarantee trading revenue tomorrow, GS has historically had a below-market P/E of 8-10. Simply put, investors are willing to pay less for profits that are one-time than ones that repeat (like a long-term service contract). The company has earnings power of about $15, which under its historical P/E parameters result in a share price of $120-$150. Because the firm is less risky than it was, I am willing to value GS at its historical high-end of 10x or $150, once again book value.
Goldman Sachs should trade at, not above, its book value. Some have argued that the company deserves a "best-in-breed" premium. I would be willing to consider that if the company were in fact "best-in-breed." Lawsuits alleging fraud that have been settled have damaged Goldman's reputation as the firm seemed to put profit above clients. Further from a financial perspective, it has underperformed competitors that take less risk. JPMorgan Chase (NYSE:JPM), which is a stock whose valuation I question, trades at an 8% premium to book value, slightly less than Goldman. Yet, the firm has a higher ROE of 12.4% and return on assets of 1.08% even as the firm has dealt with issues like the London Whale and has lower risk business with its commercial bank. Goldman should trade at a considerable discount to JPM, not a slight premium.
The pop GS got off inclusion in the Dow provides the perfect opportunity for investors to take profits. Goldman is a fine company, but the stock has gotten a little expense at 1.09x book value. Until the firm shows it can improve its return on equity above 10-12%, its stock should trade at roughly book value, or $151. Goldman should trade sideways or slightly lower from here while it looks relatively expensive compared to other financials like JPM (though I would not be a buyer of JPM here). I would exit GS and look to re-enter when it is more fairly valued.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.