Here's a fascinating stat that attracted me to GS stock in the first place. Between late 2009 and late 2018, Goldman Sachs' stock did not appreciate at all. Its only return to shareholders came from its modest dividend as you can see. Over a 10-year stretch, the stock didn't appreciate at all, and the total return was a paltry 13%:
This lackluster performance came while the S&P 500 as a whole tripled. Additionally, Goldman Sachs' tangible book value grew 68% over the same stretch. The company has generated plenty of economic profit over the past decade, but little of this has translated into shareholder returns... yet.
Back this up to the pre-financial crisis days and the performance gap is even wider:
In 2006, Goldman Sachs had a tangible book value of just $79 per share, yet the market valued its stock at as much as $200, paying almost 3x tangible book for its stock then. And note that even during the financial crisis, Goldman Sachs never had to dilute itself to high heavens to survive. During the height of the crisis, Goldman's tangible book value kept rising despite the awful conditions for banks.
It appears that the market is trading GS stock based on its earnings. In 2006, Goldman Sachs earned $24 per diluted share, and not coincidentally, it hit its peak pre-crisis stock value. Earnings dipped markedly going forward, with the company earning on average in the $15/share range after the financial crisis.
Now, after years of under-earning, Goldman Sachs is back on pace to hit record earnings levels, with analysts forecasting $25/share of EPS or so over the next 12 months. Clearly, however, the market is unimpressed with these earnings, as GS stock is now trading around tangible book value, and at just 8x forward earnings.
Let's take a moment to think about why this low valuation might be justified. Late last year, there was headline news involving a scandal out of Malaysia. It appears some of the under-performance in GS stock is due to this. However, it looks like even in the worst case, it won't cost the company more than a quarter or two of earnings. I see this as irrelevant to the long-term investment thesis.
More importantly, Goldman Sachs has been criticized for not adapting quickly enough to the post-recession change in the banking environment. While the company has made some shifts in its strategic focus, it still relies more on traditional investment banking profit centers such as market making than other large banks. Additionally, Republicans losing Congress in 2018 and potentially losing the Senate or the Presidency should stall deregulation efforts and may lead to more regulatory scrutiny going forward.
There's also the matter that this could be peak or near peak earnings. As we've seen in past cycles, banking earnings can decline in a hurry once the economy turns down. However, I'm skeptical this is the top. For one thing, investment banking revenues in particular should be booming as 2019 has been one of the hottest years for IPOs in ages. And that's a business Goldman continues to dominate. Long-time respected Goldman critic Dick Bove finally upgraded GS stock to a buy two weeks ago, acknowledging both the company's current deal and earnings momentum, while also crediting its longer-term strategic positioning:
“The core reason to buy the stock is not so much what might be a great second quarter. It is that the company is being repositioned to fit its products into the newly formed markets driven by technology."
It's important to note Goldman Sachs has a wide range of revenue sources, with none accounting for an overwhelming portion of the company's income:
Source: Annual report
That said, most of these are still tied to the health of the economy. While trading operations should make more money in volatile markets, the other branches suffer. Assets under management declines for the investment management business, the investment banking business will have fewer IPOs and other deals, and the commercial bank is likely to take more losses due to credit exposure.
So, all in all, I don't think one can say this is simply pound-the-table cheap just due to being at 8x earnings. Until recently, the firm was earning closer to $15/share per year, which would put the PE ratio now at closer to 13x. That's totally reasonable for a large bank, but not deep value either.
However, the key attraction now is that Goldman Sachs is right at tangible book value. This is incredibly weird, given how strong the economy is. The market has usually paid a premium to Goldman's book value in the past:
Only for brief moments in 2008, 2012, 2016, and this past December has this ratio fallen below 1. And all of those, in hindsight, were outstanding buying opportunities for GS stock. In theory, if the company were to liquidate, a buyer today is getting precisely fair value for the bank's real assets. One of the world's most prestigious and influential banking brands is now being valued as though the ongoing operation has no inherent value whatsoever. You have to be really down on either the economy or Goldman Sachs' corporate culture to think this makes any sense at all.
I want to repeat that I'm not sure how sustainable $25/share earnings will be. I'm more bullish on the economy than most, and expect stocks to perform nicely over the next 12 months. Beyond that, though, we are overdue for a recession at some point, and Goldman's earnings will almost certainly decline when it comes.
However, the value driver here is the steady increase in tangible book value. Between its strong retained earnings and share buyback, the company has compounded shareholder value at a ridiculous clip. Goldman has retired 25% of its outstanding stock since 2011, for example. That's an amazing achievement. Ultimately, it hardly matters if they earn $25 or $15 a share in any given year, tangible book value will continue compounding at a solid pace, dragging the share price up over time:
This is the inherent value of the business; ignore the stock market fluctuations. A business that is growing like this should earn shareholders a good deal of money over time.
Huge Dividend Hike
Up until now, few people have owned GS stock for its dividend:
Since the financial crisis, GS stock has never yielded more than 2%, and it has only rarely even been above 1.5%. If you owned GS stock, you were buying it mainly for capital appreciation. However, we're about to see a big switch in the shareholder base. That's because Goldman Sachs just announced a monster dividend hike in conjunction with the recent Fed stress tests, which GS passed with flying colors.
In response, Goldman is raising its dividend by a stunning 47%:
The new dividend will be $5/share annually, which pencils out to a 2.4% dividend yield on the current stock price. Is that a huge yield? No. Does it easily top the S&P 500 and get it into competitive range with the other too-big-to-fail banks? Absolutely. A lot of value funds that prioritize dividends should move into GS stock once the dividend takes effect. A lot of DGI folks will see GS stock on their radar for the first time as the company will sport huge 5- and 10-year compounded dividend growth rates once this move takes effect.
Notably, even with a 2.4% dividend yield, the dividend payout ratio will still be down around 20%, leaving plenty of room for more hikes going forward. The bulk of Goldman's capital return program is still in its stock buyback, which makes sense with shares so cheap at this valuation. But once Goldman's stock returns to a more appropriate valuation, the company can fund a much higher dividend going forward if it lacks better uses for its capital.
Finally, for those more trading-oriented, it'd be totally logical to buy here, and wait for the market to return to optimism and pay 1.5x TBV again at some point in the future - up around $300/share at the moment. Strongly rising book value plus multiple expansion will create a very favorable trading opportunity if I'm right and the economy doesn't grind to a halt over the next 12 months.
This is an excerpt of an Ian's Insider Corner digest published December 2018 and updated to reflect subsequent events. Subscribe now to get the full edition of this and all future digests. Ian's Insider Corner membership also includes an active chat room, initiation reports for new stock purchases, and my responses to your questions.
Disclosure: I am/we are long GS. 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.