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Goldman Sachs (NYSE:GS) reported that its third quarter net earnings reached $1.51 billion, a turnaround from the previous quarter's loss of $393 million. This translates to earnings per share of $2.85, beating consensus analyst estimates of $2.12 per share. These are relatively good financial results amid challenging global markets and a prolonged European debt crisis. The robust results were attributed to the gains from its investment banking and bond underwriting. Its investment portfolio also posted significant gains after last year's losses.

For the current fiscal year, analysts expect the bank to earn $11.70 per share, or an increase of 159% compared to the previous year's levels. For the next 5 years, analysts expect the bank to grow its earnings by 20% a year. Given the previous quarters' performance, it seems the bank is way behind the consensus estimates.

Revenues for the quarter reached $8.4 billion, more than double from the previous year's results. Major business segments have performed relatively better than expected. Its investment banking business posted revenues of $1.2 billion, an increase of 49% compared to the same period last year. The increase is due to better than expected revenues from underwriting business, albeit lower from its financial advisory business.

On the other hand, its institutional client services and investment and lending division contributed revenues of $4.2 billion and $1.8 billion. This translates to 3% growth for the institutional client services and reversal from last quarter's negative revenues of $2.5 billion. The outstanding performance from its fixed income currency was offset in the performance of its commodities desk.

Furthermore, the fall suggests that its clients' transactions and orders have yet to normalize. Also, the fall in equity trading revenues contributed to the lower commission revenues and fees. Finally, its Investment Management generated revenues of $1.2 billion, a slight decline of 2% from the prior year. The reduced revenue from this division is due to decreased transactions and management fees.

In terms of peer performance, Citigroup (NYSE:C) reported modest results after it posted earnings per share of $1.06, beating consensus estimates of $0.98. Banking giant JPMorgan (NYSE:JPM) reported third quarter earnings per share of $1.40, beating expectations of $1.21 earnings per share.

Lesser Risk Means Higher Dividends and Share Repurchase

Despite the robust results, Chief Financial Officer David Viniar remained cautious over the course of the next 12 months. He cited that the US presidential elections and the European crisis will continue to weigh on the bank's earnings for the coming quarters. This in turn translated to management's decision to lower its risk capital. In fact, its daily average value at risk has declined to $81 million, the lowest level in 6 years. This means that the company is going back to its fundamental principle of capital preservation.

While Goldman Sachs has the reputation for being one of the savviest banks in Wall Street, it has succumbed to high-levels of risk taking. This resulted in the bank's return on equity to decline. Goldman Sachs reported return on equity of 3.65% in 2011, a significant decline from the return on equity of 11.36% posted in 2002. In terms of return on equity, shareholders usually expect banks to post return on equity of 15%. During the peak years, Goldman Sachs reported return on equity in excess of 30% in 2006 and 2007.

In contrast, JPMorgan has reported consistent increase in its return on equity. It reported return on equity of 10.21% in 2011, an increase from the return on equity posted of 3.96% in 2002. Citigroup has return on equity of 6.50% in 2011, also a decline from the return on equity of 18.41% in 2002. Also, Morgan Stanley (NYSE:MS) posted return on equity of 3.82% in 2011, a decrease from 2002's return on equity of 14.14%.

This means that Goldman Sachs will be inclined to return cash to its shareholders through share repurchase and dividends. At the current levels, the bank has dividend yield of 1.60%. This is lower than the industry's dividend yield of 1.97%. During the current quarter, Goldman Sachs declared dividends of $0.50, an 8.7% increase in dividend from the $0.46 paid in the last quarter. It also announced that it has repurchased 11.8 million shares at average price of $106.17, or equivalent to $1.25 billion. It still has remaining authorized repurchase of 34.2 million shares.

Going forward, I expect that it will pay off at least 20% of its net earnings to shareholders. Meanwhile, management has also bought back shares amounting to almost a billion for the last 3 years. This will continue to increase as it targets to improve its return on equity in the coming years. Another reason why Goldman Sachs can afford to increase its dividends is its strong capital ratios. It has Tier 1 capital ratio of 15%, in line with the previous quarter. Tier 1 common ratio is also at 13.1%, also in line with its previous quarter.

Valuations

Goldman Sachs is currently trading at 10.1 times earnings and 90% of book value. It also carries a dividend yield of 1.60%. Wells Fargo (NYSE:WFC) is valued at 9.3 times earnings and 1.3 times book value. It has a dividend yield of 2%. Meanwhile, JP Morgan trades at 8.1 times earnings and carries a dividend yield of 2.7%.

It seems that investors have yet to be convinced that these major banks will have better than expected profitability in the future. If you look at earnings quality of the recent quarter, Goldman Sachs posted gains from the increase in asset prices. Investors demand earnings sustainability in the coming quarters. The key investment thesis would be a stronger macroeconomic environment for Goldman Sachs to support modest returns on equity rather than increase in asset prices. While it seems unusual for Goldman to return cash to its shareholders based on historical perspective, I believe this is the best capital allocation decision for the current environment.

Source: Investment Firm Ripe To Buy In Q4 For 2013 Gains