Goldman Sachs: A buy at tangible book value (NYSE: GS)
Investment banking giant Goldman Sachs (NYSE: GS) has had two eventful years. The stock doubled not too long ago on the back of sharply improving earnings in 2021. Since then, however, the stock has fallen back to near 52-week lows as the near-term earnings outlook has darkened amid a weaker economy:
There is no doubt that Goldman Sachs will face a more challenging operating environment in the coming quarters. However, I think traders worry too much about short-term swings. Instead, I would urge investors to consider valuing Goldman Sachs based on book value rather than quarterly results.
GS stock: my favorite chart
My favorite way to look at GS stock is to compare price to tangible book value (P/TBV). It measures the valuation of a bank in relation to the net asset value of its balance sheet. A bank’s profitability is determined by its balance sheet and the level of income it can earn on those assets, so book value ends up being a key part of a bank’s long-term value proposition.
Here is how the GS ratio has changed over time:
Before the financial crisis, Goldman Sachs was trading at two or even three times its tangible book value. This made sense because Goldman was constantly and rapidly increasing its tangible book value, regardless of economic conditions or short-term earnings.
In the wake of the 2008 financial crisis, however, GS stock plunged to a low P/TBV of 1s and then spent the past decade plodding around 1.0x the tangible pound more or less a small fork.
I was aggressively buying GS shares in 2019 when the shares were at 1.0x P/TBV, arguing that it was far too cheap for such a high quality bank with consistently strong profitability and operational metrics . At the time of my purchase, I was hoping that GS could rally towards 2x P/TBV in a better interest rate environment and with more positive sentiment for the banking sector.
It was played out partially; Shares of GS are up 50% against the tangible pounds last year. Now, however, it’s back to 1.0x once again. The investment hasn’t been bad by any means, however. Indeed, regardless of how the economy plays out, GS stock continues to increase its tangible book value at a breathtaking rate:
In 2019, I was buying the stock around $200 with a tangible book at $200. Now the valuation ratio is the same, but the stock price and book value have reached $300. This is the way things go when you have a classic compositing operation like first thing. Going back a bit, I note that the book value of GS continued to rise steadily even in 2008 and 2009, when the rest of the financial industry was collapsing. Goldman Sachs has a reputation for being the smartest investment bank in the country and there’s a good reason for that.
Rising book value, dividends and multiple expansion
Even if Goldman Sachs’ stock price only followed its tangible book value, it would be a sizable investment, as its tangible book has risen from less than $40/share at the turn of the century to $290 today.
But there’s more to it than just the steady increase in its balance sheet. On the one hand, the company offers a reasonable dividend. After aggressive rises in recent years, GS stock now pays $10/share in annual dividends, which equates to a solid 3.2% return following the stock price sell-off. Add in a starting dividend yield of 3% on top of nearly double-digit annualized growth in TBV, and things are gearing up.
Then there is the multiple. As noted, in recent years GS stock has tended to approach the 1.0x P/TBV level. However, it reached 1.5x in 2021 and was consistently above 2x before the financial crisis. A T/PBV of 1.5x would put the stock near $450 today, and a multiple of 2x would take it to $579.
I’m not the only one who thinks GS stock is worth over $400 per share. Morningstar’s Michael Wong just raised his price target for GS stock to $438 per share in July this year. Wong shares my thought, writing:
“We believe the company should be trading at 1.5 to 1.6 times tangible book value.”
Wong attributes this higher valuation multiple to the bank’s larger and more profitable investment management operation, a growing revenue stream from consumer businesses and better expense control, among other factors.
The profitability of Goldman Sachs
The problem with measuring too-big-to-fail banks on short-term earnings is that there are a ton of moving parts that make up the calculations. You have things like loan loss reserves, mark-to-market accounting, etc., which can greatly impact profitability over a three month or even a year period.
Goldman Sachs currently looks exceptionally profitable on a rolling basis, and many people have been making bullish theories for the stock based on its single-digit P/E ratio. They are not wrong, exactly, but the reflection is incomplete.
To zoom out, consider Goldman’s return on equity “ROE” over the past decade:
ROE is a bank’s return on its assets at book value – essentially the profit it can make from every dollar of equity it puts to work. Over time, a bank’s returns depend on how much capital it uses and how profitable it is to deploy. As we saw above, Goldman Sachs has grown in book value incredibly quickly. Now let’s look at return on equity.
Over the past decade, ROE has been very stable, almost always between 8 and 12%. That’s pretty good for a major US bank in a low interest rate environment. An ROE of 8% would be considered pretty average, and a reading of 12% is pretty good, but not best in class.
Since 2020, however, Goldman’s ROE has reached stratospheric levels. This explains the massive profits and the very low P/E ratio. Goldman was suddenly able to get up to twice the return on every dollar invested.
However, this period of excess earnings seems to be coming to an end. The frenetic pace of activity in areas of investment banking such as IPOs and mergers and acquisitions is slowing. Asset management fees go down as the value of the markets goes down. More and more transactions go wrong, leading banks to incur losses in the course of their business. Now Goldman is reportedly laying off workers as it retreats to a less prosperous trading environment.
But, that’s all normal cyclical stuff. Short-term profits go up and they go down. The difference here is institutional. Goldman has superior risk management and capital allocation, and is therefore able to avoid losses and even continue to make money in dismal market conditions like 2008.
While earnings and ROE rise and fall from time to time, the tangible book value of the bank has steadily increased in virtually all market conditions. And with P/TBV back at a low level, the downside is limited from the current entry point. In the meantime, it’s not at all hard to imagine a strong pick-up in sentiment for the banking sector and GS stocks in particular as soon as the Fed pivots and capital starts to flow a little more freely.
I expect Goldman to be able to normalize its ROE at or above 12% once we enter a more normal set of economic conditions and that should support a significantly higher valuation than we are at. are today.
Long story short, I expect GS stock to break above its all-time high of $426 per share over the next 12-24 months. And, thanks to its recent dividend increases, Goldman is now a surprisingly strong income option with a healthy 3.2% yield on offer today.