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Summary

  • Goldman Sachs' return on equity is below the normalized level.
  • The business is slightly undervalued, presenting a potential yield of 15% over the next year.
  • Creating a position on a pullback is recommended.

The Goldman Sachs Group (NYSE:GS) provides investment banking, securities trading, and investment management services to corporations, financial institutions, governments, and high-net-worth individuals worldwide. It operates through four segments: Investment Banking, Institutional Client Services, Investing & Lending, and Investment Management. The corporation has never operated under an unprofitable year, but as an investment bank, it has experienced continuous peaks and troughs of earnings throughout the decades. Considering the volatility of earnings, correlated to client activity and market ebb and flow, these financial firms tend to have lower price-to-earnings ratios than most Fortune 500 businesses. The current S&P 500 P/E is 19.24, with a historical average of 15.51 and median of 14.55. But people should not classify these businesses as "cheap" when comparing to other sectors in the SPDR S&P 500 (NYSEARCA:SPY), since each sector varies.

Key Driver

Financial firms cannot be valued based on free cash flows like other corporations, because cash consistently moves in and out of the business like water in a river. Instead, people should look at the corporation's return on equity, which obviously corresponds to the firm's return on assets:

GS Chart

GS data by YCharts

Since the financial crisis was an anomaly to almost all corporate performance, I kept it out of the equation and looked at the last 5 years. In 2010, ROE hovered around 20%, considering most of the returns made related to the relief rally, return to the norm, and high volume with respect to services and products. Conversely, in 2011, Goldman Sachs' investment banking and trading divisions abruptly suffered quite a bit of revenue loss due to abnormal circumstances and a weak year for U.S. indexes. Using a linear regression equation over the last ten years shows that return on equity should be around 15%, ~5% higher than where it currently stands. In the last several months, banks - such as Citigroup (NYSE:C) and JPMorgan Chase (NYSE:JPM) - have suggested that once again, revenues and of course, earnings, will suffer to due slowing market activity (likely related to less volatility within financial markets). With that said, investors appear to have slightly adjusted for that already in the last quarter by reducing positions within these institutions. Despite worries pertaining to QE tapering, ROE and ROA will likely be driven higher as the economy improves and cash is injected into capital markets. The 15% ROE metric for Goldman Sachs is attainable over time, and in my opinion, 11-12% may be reached within the next year or so.

Standard & Poor's Evaluation

S&P's Stock IQ report suggests that growth drivers appear to be shifting away from trading into investment banking and management for clients. In the analysis, it assumes revenues will not only stagnate but instead possibly decline in 2014, with nominal improvement in 2015. Compensation costs also remain one of the highest expenses, weighing in on earnings for the firm. Its 12-month price target is $160, slightly below its current trading price, reflecting multiples of other leading global banks.

Goldman Sachs' performance will obviously correlate to capital markets, but I think Standard and Poor's is being a little too conservative here. In my view, if we see any significant pullback, possibly around ~10%, that will generate an interim short-term setback, but ultimately provide an opportunity for prospective shareholders.

Valuation I

A discounted cash flow model gives investors a preliminary view of what a firm may be worth; adjusting input around analyst estimates can generate a more accurate picture. At $15.20 EPS with 7% annualized growth, and no terminal growth, the model provides a value around $183 - almost 14% upside, not including a dividend yield. Using the $17.00 forward estimate is not helpful, in my opinion, since most analysts concur that sufficient earnings growth may not materialize in the next couple of years.

I also decided to project a simple financial model on the company, using a power function that is most tightly fitted for projecting future earnings:

This chart takes into account past figures, estimating that earnings will reach ~$8800mm by 2014 and ~$9300mm by 2015. Unfortunately, this theoretical model does not consider the variable of earnings volatility, but in effect, it already incorporates the worst-case scenario of $2 billion and best of $13 billion. Right now, we are in the middle of the two, so this is where one's own educated assessment comes into play.

Valuation II

As I said in the beginning, ROE is a much better indicator of a financial firm's output and profitability. Here, I used a dividend discount model to evaluate Goldman Sachs' position. All of the following inputs were last year, current, and normalized figures: BV of equity, dividends, risk-free rate, growth rate, ROE (12%), and of course, earnings.

Value of assets and fair value sits at ~$184 per share, which is oddly very close to the DCF output. When adjusting the risk-free rate between 3% to 5%, these are the following fair value results:

  1. 3% = $211.86
  2. 4% = $184.07
  3. 5% = $161.94

Even though 3% is considered the risk-free rate at most times, I think adjusting it higher gives us more conservative (and safer) estimate for investors to rely on. In my opinion, shares are probably worth somewhere north of $180. In decent times, Goldman Sachs has achieved a normalized market cap of $80 billion (occasionally peaking around $95 billion), and I don't see why it cannot achieve that again.

Gauging Sentiment

Goldman Sachs is a renowned firm around the world, and continues to show a high level of expertise, not only showing unrelenting years of profitability, but risk management as well. As many people know, Buffett has a pretty large stake in the business, and continues to enjoy having it as a holding. Recently, over the news, people were discussing that Goldman Sachs and Coca Cola (NYSE:KO) are two of his biggest underperformers. While to most that rings a bearish tone, others believe it signals opportunity. Some investors claim companies that are underperforming in price relative to others in the DJI, it should catch up over time. I personally have never analyzed this statistically, so I cannot support it.

Technician Analytics

There's a lot to be said about Goldman Sachs' chart, but I will keep it simple. Several months ago, it was much easier to decipher with standard support and resistance, but in 2014, it's a different situation, so I'm overlaying indicators to see where it may move.

In the price chart itself, there is a large support line at $151, typically an area you want to buy (provided the market continues to charge higher, but seeing this level may be unlikely). Descending resistance coming down in the mid $160s can generate a profitable trade on a breakout, but usually requires a quick exit strategy. The rising wedge and Williams indicator are bearish. While the vortex and MACD are bullish. All daily moving averages are neutral.

Bottom Line

Even though we are not getting a bargain like back in 2012, sentiment still seems favorable at these levels. Technically, the stock looks neutral, but I would recommend waiting for a pullback. With the VIX pent up and the market reaching all-time highs, we should be able to see a lower price. Overall, I think Goldman Sachs presents good value, and it can head higher at least another 10% to 20%, especially if we see an unexpected boost from earnings; or in my view, an expected boost.

Source: Goldman Sachs: A Decent Price