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Furthering the Conversation on Investment Bank Valuation
As mentioned in my previous posts, I have been engaged in a discussion
of the valuation of Goldman Sachs and investment banks in general. For
the background behind this discussion, reference "Reggie
Middleton vs Goldman Sachs, Round 2" and "Readers
Comments on Goldman's Valuation".
Here is how it has played out.
ANALYST: Do you think GS or any other bank that
is seen as a going concern should be valued at PB anymore, particularly
now that the recession is over. I don't think markets are valuing banks
seen as going concern on P/B (particularly xx/subs content used for GS).
Let's say it this way. I know the merits of PB
but shouldn't it be used to value banks during recessions. Post
recession, historically as well, analysts and markets switched to
alternative valuation method for banks since PB would give us a base
value during recession, and is good proxy during liquidation process
that would determine shareholders' value in case bank has to wind up
Assuming GS has ROE of 15%. What about future
cash generation now that we have revenue visibility? Or probably you
don't expect GS to survive for next 5 yrs. Ok let's say this way, If you
value GS with PB of xx with ROE of 15% two years down the line you
would expect the book value to increase by 32% (assuming 0% payout
ratio) and in five years more than double. Given that I-banks have high
ROE this would be conformist, and not "realistic" as some argue, to
value an I-bank.
Ideally banks (both commercial and investment
banks) should be valued on discounted cash flow methodology taking into
consideration cost of equity and future cash flows. But since banks have
highly liquid balance sheet, traditional DCF used for industrials might
ignore the merit in current balance sheet strength. So there is a need
to maintain a trade-off that considers both the virtues - balance sheet
strength and future accretion.
RM: Keep in mind that either GSs interest costs
will go up or their trading revenue will most likely go down if
regulation is enacted, and from a political perspective global
regulation seems inevitable. I believe the revenue prospects for the big
banks are overrated. One plus will be that compensation costs may be
forced down across the board as a cultural shift, but if the banks
argument is to hold water (which I believe it will not) then they will
suffer a flight of talent to lesser regulated entities.
Why would you believe you have more revenue
visibility now with the entire industry in flux, not to mention the
business landscape? GS is coming off of the biggest real asset, credit
and financial asset bubble of the last 70 years and is still benefiting
immensely from government intervention. Do you really believe that Wall
Street banks have an upward revenue curve from here once interest
rates begin to rise, regulation increases, and government support is
wound down?
ANALYST: My comment was that in recessions PB was
probably the method. During recession markets are worried about
sustainability, so they place high regards to Price-to-book and
Price-to-tangible ratios. If you remember last year, there was so much
of emphasis on leverage, tangible equity capital ratio, level 3 assets
on so on. Now after the govt intervention, we don't expect to any more
massive failures. And hence relative importance of PB diminishes.
What the intervention has done is passed the
costs to future generation for the time being. Even if revenues are
expected to decline, there is less noise about sustainability. Even if
revenues are expected to decline, as long as a company is able to earn
higher return than cost of capital, markets would be ready to pay a
price higher than BVPS. Wont you?
And about higher trading revenues, GS trading
desk hardly generates alpha. It's just beta, as per your earlier
analysis. If you have a negative view on market, GS would be a good
opportunity to short. But then the question is about the market. Of
course, once QE is withdrawn, and private spend would not be able to
fill the gap that fiscal has done to the economy, we could expect some
huge sell off. Till that time I would personally ride with the markets
until I see clear signs of QE easing and Fiscal spending withdrawn. It's
just a matter of time.
I was not able to express all my thoughts but I
think you got my view. But my argument was more on valuation than view
on markets.
RM; It looks as if the markets are about to
break. We have had a very strong rally against the fundamentals (and the
technical's) for nine months now. We shall see if that is the case. As
for banks failing, once a mechanism is in place to liquidate banks I
don't think the argument will stand that the big banks won't fail. They
will fail if they don't succeed. There is a lot of political acrimony
involved in bailing out the banks and I don't think it can be done
publicly in the very near future. With that being said, nearly all of
the conditions that caused the other banks to fail are still here, save
liquidity - which the government has supplied.
RM: GS return on equity has declined
substantially due to deleverage and is only marginally higher than its
current cost of capital. With ROE down to c12% from c20% during
pre-crisis levels, there is no way a stock with high beta as GS could
justify adequate returns to cover the inherent risk. For GS to
trade back at 200 it has to increase its leverage back to pre-crisis
levels to assume ROE of 20%. And for that GS has to either
increase its leverage back to 25x. With curbs on banks leverage this
seems highly unlikely. Without any increase in leverage and ROE, the
stock would only marginally cover returns to shareholders given that
ROE is c12%. Even based on consensus estimates the stock should trade
at about where it is trading right now, leaving no upside potential.
Using BoomBustBlog estimates, the valuation drops considerably since we
take into consideration a decrease in trading revenue or an increase in
the cost of funding in combination with a limitation of leverage due
to the impending global regulation coming down the pike. Using your
method, our valuation would drop from where it is to an even lower
point.
I definitely do understand your perspective,
although I would have to give it some more thought before I can label it
"the right way to go".
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You have to factor in that GS managed to have their rivals assassinated.
Less competition, good for GS, bad for everyone else, but a rival investment bank rising up to offer lower cost services is essentially impossible as GS is a government mandated quasi monopoly in many of its markets (with a profits and compensation structure of an entrepreneurial firm, but that's a separate point!)
again....take a look at MQG AU - the most expensive investment bank in the world
THERE'S that square root shaped recovery that everyone's been talking about. Oh wait, that's not the S&P, that's just ROE guesses for some piddlin' investment bank. Poor bastards, not everyone can be Goldman's Schmekel.
Wow! Quack, quaint, quarrelsome, questionable, quick, quickest, quiet, quixotic, quizzical.
Reggie does it again with an outstanding, wonderful article!
Reggie gives us hope for change in the banking industry.
Copy / paste! This is great. Reggie, Reggie!
Kissy.
I've noticed that you appear to be stalking Reggie, jumping on his threads to make fun of him, which isn't particularly cool.
If you want to disagree with the man, how about posting at least something that has some financial or economic content within.
Add some content or just leave and refrain from being an asshole.
Disclosure: I don't know Reggie, have no r'ship, but do appreciate his detailed analysis of banks, reits, etc.
I know, there, there DH. You are the original Kissy Ass of Reggie. You need your credit so here you go, and I don't mean to steal your thunder.
(Idea) We can both be Kissy Ass of Reggie. OK? (Tyler too but you haven't requested that yet and I know you beat me to it but I promise to be a good Kissy Ass of Tyler too. OK?).