Goldman Sachs and the Faulty Ivory Towers

Includes: GS, LEH, MER, MS
by: Victor Cook

This is the 6th post in my series on the competition for customers and capital among leading investment banks. The players are Goldman Sachs (NYSE:GS), Lehman Brothers (LEH), Merrill Lynch (MER) and Morgan Stanley (NYSE:MS). In it I discover why investors believe net income is the top line for investment banks.

In the post on "Morgan Stanley, Merrill Lynch and the Fable of Three Bears" I defined the variables in my four factors model: competitors' enterprise marketing expenses [f], strategic group revenues [R], company percent gross margin [g dot] and company enterprise marketing efficiency [x]. Maximum earnings market share, symbolized in this chart as "m hat," is a non-linear function of these variables. You will find a proof of this model in my book, Competing for Customers and Capital (pages 251-52).


In most businesses, it happens that revenues and gross margins are pretty clearly defined. Take supermarkets for example. Revenues are the value of goods sold less returns and allowances. The percent gross margin is the ratio of revenues less the cost of these goods divided by revenues. I believed the same revenue-margin model should be applied to investment banks by viewing revenues as the value of all services sold plus interest income. Interest expenses then become the "cost of goods sold" and gross margin is calculated just as it is in supermarkets.

Following this approach, Goldman Sachs' gross revenues were $20.4 billion in May, 2007, interest expenses were $10.2 billion, so its gross margin was 50%. In case you want to calculate Goldman's maximum earnings market share, here are the other three inputs to the four factors model: f = $17.3 billion, R = $85.1 billion and x = 1.17.

From the first post in this series on "Citigroup's Enterprise Marketing Expenses: The Middle Line," I adopted the intermediation approach to bank operations.

Manufacturing companies can easily load overhead expenses into the cost of goods sold without anyone noticing. From an intermediation perspective the "cost of goods sold" in banking is interest expense. And banks aren't allowed to load overhead into interest expenses.

I was advised in a comment that "this is not the way practitioners see banking operations." And in a later comment that, my analysis "will be most convincing to the practitioners if presented with the vocabulary familiar to the practitioners." But I remained convinced that the intermediation approach was the only way to go. In my post on "Double Bull's eye for Morgan Stanley," I attempted to shut out the "net income" approach with a quote from the Journal of Money, Credit and Banking. Why was I so committed to intermediation?

If banks actually had a zero cost of goods sold, like electronic futures exchange markets, my analysis would work just fine. But since interest expenses are a significant cost of doing business, ignoring them would cause distortions in a company's enterprise marketing efficiency and hence its maximum earnings market share.

This is true, but there's a larger issue. If all practitioners (both managers and investors) believe net income is an investment bank's top line, my theoretical distortions become their reality.

Over the last week I began to apply my competitive stock valuation model to these four investment banks in preparation for a future post in this series. I've applied the model to over a hundred companies and it usually produces reasonable results. But the results for these banks weren't reasonable. I checked all the inputs and still the results didn't make sense. Predicted stock prices in May, 2008 were not consistent with closing prices in May, 2007. So I ran the numbers on net income and found a huge effect influencing investor perceptions. This table tells the story for Goldman Sachs.


Using the net income approach (green), group revenues fall 56% from $85.1 to $37.1 billion. But practitioners don't (yet) look at group revenues in making investment decisions, so this doesn't matter. Though Goldman's net revenues drop 50%, this is the way practitioners see banking operations. Gross margin is now 100%, so gross profits remain unchanged at $10.2 billion. Enterprise marketing expenses and operating income before depreciation also are unchanged. But using the net income approach has a huge effect on an important bottom line ratio: earnings to revenues are less than half (4.5%) in the intermediation approach compared with the net income approach (10.3%). In short, what amounts to distortion in theory is reality in practice.

So I've been trying to figure out why practitioners use net income, even though interest expenses are so important. Well, with all the focus on interest rates these days I finally saw the light. Interest expenses can't be treated as cost of goods sold because management has no control over the fed funds rate!

I should have listened to my reviewers' comments. Instead I succumbed to a weakness that inhabits the ivory towers ... the reluctance to give up a cherished approach to any problem. Needless to say, in my next post I'll use income net of interest.

What do you think?

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