Goldman Sachs Still Hasn't Recovered From The Crisis

| About: Goldman Sachs (GS)


Goldman Sachs' profitability levels haven't recovered from the crisis.

This is keeping a lid on its valuation and the stock price as its earnings continue to recover.

But given where it is in the cycle and in relation to Morgan Stanley, it looks fairly valued here with few catalysts to boost ROE and the valuation.

Click to enlarge

Ever since David Schawel came out with his paper describing the valuations of financials in relation to their returns on equity, I've been examining the big US financials in an attempt to understand where they've come from and where they may be going. This, in light of the currently depressed valuation of the sector as a whole, has yielded some interesting insights. In this article, I'll take a look at Goldman Sachs (NYSE:GS) to understand its ROE levels since the crisis against current production as a different way to value shares.

I'll be using the chart below, which I created using data from company SEC filings.

We'll begin by taking a look at the chart as it contains all the data pertinent to the discussion.

Click to enlarge

This chart contains a lot of data so let's take a look first at the bars as they give us an idea of GS's capital structure throughout the years since the crisis. The red bars are long term debt, which GS defines as long-term unsecured obligations. The green bars are the company's total shareholders' equity for each year and the blue line is GS's net income on that total equity number, or its ROE.

The first thing I noticed about this chart is that GS's balance sheet size is remarkably similar to what it was coming out of the crisis. Other big banks like Bank of America (NYSE:BAC) and JPMorgan (NYSE:JPM) have seen gigantic expansion in their respective balance sheets due to acquisitions and outright growth since the crisis but GS has been largely unaffected by those activities. In fact GS was shrinking its balance sheet very steadily until 2014 when it saw a small uptick that was followed by a similar move last year. On the whole though, GS has seen relatively little movement in the size of its balance sheet the way I've defined it here.

The second thing I'd like to point out is that GS carries a lot of debt in relation to equity compared to its more traditional bank competitors. After the crisis, GS saw 2.6 times the amount of debt on its balance sheet as equity and while it has made progress in recent years, that number is still slightly in excess of 2. While that is certainly a manageable number, with fewer and fewer places to invest capital in a ZIRP-heavy world, it seems GS has opted instead for a lower amount of debt and less money it has to find a profitable place for.

Its equity, on the other hand, has averaged 4.5% growth annually since 2008, a strong showing to be sure and in particular, in light of the fact that 2011 saw equity shrink by almost 10%. That has clearly proven to be an anomaly and the rest of the time, GS has just continued to build its equity position. Part of the reason is because it has been quite profitable under most circumstances but also because its capital returns heretofore haven't been great.

GS pays a much lower dividend than the other large banks including Morgan Stanley and its buybacks - while certainly present - haven't been earth-shattering. Citi has witnessed a similar impact on its capital levels albeit, at a much higher magnitude. At any rate, GS's ROE has been held back somewhat by its constant builds of capital, increasing the denominator and making that much more challenging for the numerator to keep pace as earnings growth has been hard to come by.

Speaking of ROE, GS hasn't exactly been impressive their, either. After a 3.2% showing in 2008 (while many others were negative) GS hit the high teens in 2009 but has been rather average since then. The years of 2012 to 2014 saw a steady string of 9.6% to 9.8% - respectable numbers in today's world - that gave way to just 6.4% last year. This year GS is off to a better start with a 7.5% showing in 1H2016 and a much better 8.7% in Q2. Those are better numbers, but GS is certainly not up to its old ways.

So know that we know where GS has come from, where can we reasonably expect it to go and what would that do to its valuation? GS's ROE should be helped out in the coming years by the firm's increasing propensity for capital returns. GS has never been much of a dividend stock and while it still isn't, it is getting better. And while we don't know how much GS has allotted for buybacks (a policy I cannot stand, if I may get on my soapbox), we do know with reasonable certainty that it will be multiple billions of dollars. Returning capital at that rate and subsequently doing it all again next year and beyond will at a minimum slow the rate of build of capital on GS's balance sheet. That should allow GS to build its earnings and divide those earnings by a lower amount of equity, thus increasing ROE.

In short, GS has had too much capital in the recent past, in particular 2015, to do something profitable with all of it. This is certainly not a GS-specific problem as virtually every big bank has had the same issue. But GS has been rather pathetic by its own standards for the last few quarters and while Q2 was an improvement, we still have a long way to go. And with so much of GS's revenue tied to happy markets around the world, I'm not sure all-time highs are where I want to be jumping into GS; the potential for a poor revenue environment for GS is too great.

I said before earnings that GS was a buy and the stock was up ~$20 in a couple of weeks heading into the report. But now that the Q2 report is out, I've come to the conclusion that the stock is fully valued here. There are too many questions about how GS is going to grow earnings if indeed the you-know-what hits the fan here in the US and the S&P actually sees a correction (imagine that!). GS's earnings and shares haven't performed particularly well in those kinds of environments in the past so if indeed that is coming, I don't want to own GS. In addition, it seems the days of mid-teens or higher ROEs may be gone for GS. It hasn't hit 10% ROE since 2009 and that was very clearly a blip instead of a new trend. GS seems to have become more average than it used to be and for me, I'd rather own Morgan Stanley given the circumstances. GS is going to have a very hard time generating a higher valuation with a lid on its ROE potential and that's good enough for me to look elsewhere.

Disclosure: I/we 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.