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A knowledgeable reader, who is currently a sell side analyst, questioned me about using book value to value Goldman (NYSE:GS) and investment banks in general. He proposed using a formula that entails revenues as well due to the fact that the main concern during the crisis was breakup value while revenue visibility is clearer now that the crisis is over.

Without going into the merits of his valuation suggestion (I am allowing him to make a more compete argument with me), this suggestion does bring up several pertinent points. For one, while the crisis may be over, the root causes of the crisis have went nowhere, and the counterparty risk concentration is actually much worse than before. In addition, not only is it political suicide to attempt to bailout another bank, I think it is poor economic policy as well. Combining these two assertions, it is not clear that we will not see anymore bank failures. The probability of such has dropped considerably though.

In terms of revenue visibility, I simply don't see it as a positive. Though we have more revenue visibility, that visibility points to lower revenues since:

  1. we have just come out of a credit, financial asset and real asset bubble;
  2. we have just re-entered another financial asset bubble and an attempted (and very foolish) reflation of the real asset bubble due to Fed liquidity measures and virtually zero interest rate policies which also happened to;
  3. cause an unsustainable spike in banking revenues

gs_rev_bubble.png.

As you can see from the graph above, Goldman's net revenues are nearly twice what they were during the bubble, and are even higher than they were at the PEAK of the bubble. This is, of course, after a drop to the negative zone when the bubble actually popped. This unstustainable pop was due primarily to the government dropping the cost of business for Goldman to near zero. Notice the inverse relationship of interest expense and net revenues. In addition, notice how quickly revenues have dropped (the spike and fall are due to trading), despite the act that rates have not risen yet. Goldman was able to ride higher revenues on the back of higher rates due to a credit, financial and real asset bubble. Without said bubbles, and with a potential rise in interest rates, Goldman's revenues have nowhere to go but down from here.

So, the argument of book value versus net revenue is highly academic. I see significant headwinds for Goldman's stock unless actual multiples increase. Goldman is already trading at a significant premium to its peers, despite the fact that the regulatory spirits are circling its most prolific and profitable net revenue source - trading. Does it deserve this premium moving forward?

See Reggie Middleton vs Goldman Sachs, Round 2 for the post that sparked this discussion. I will now start working on the Central European and China info to ready it for distribution to my blog.

Disclosure: short GS
Source: Commenting on Goldman's Valuation