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.

gs_roe.jpg

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".