Goldman pulls value out of adversity

January 11, 2011

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

NEW YORK — Overwhelming public opprobrium played a hand in Goldman Sachs’ decision to disclose more about its trading and investments for its own account — the first fruits of which emerged in a regulatory filing on Tuesday. But the Wall Street firm’s reorganization of how it reports earnings also serves its own purposes. It makes valuing the firm a bit easier by enabling a better sum-of-the-parts analysis than was previously possible.

Let’s start with “Institutional Client Services,” the segment which houses all Goldman’s trading and market-making for clients, and accounts for some 60 percent of the firm’s revenue. Being newly scrubbed of any outright proprietary or “prop” trading means it’s reasonable to compare this to a firm like, say, Knight Capital. Sure, Goldman’s business is larger, but it also probably takes more risk. On Knight’s valuation multiple of around 11.5 times estimated 2010 earnings, Goldman’s unit is worth an eye-popping $59 billion.

Now for “Investment Management.” The division is worth around $9.5 billion if ascribed BlackRock’s price-to-estimated earnings ratio of just under 19 times. Goldman’s “Investment Bank” group, meanwhile, is arguably comparable to financial sector specialist Keefe, Bruyette & Woods, and on that firm’s valuation multiple Goldman’s market-leading franchise is worth around $21.5 billion.

All in, that’s $90 billion, or $3.5 billion more than Goldman’s market value on Tuesday. On this back-of-the-envelope analysis, which annualizes Goldman’s pre-tax earnings for the first nine months of last year and assumes a flat 33 percent tax rate, that suggests shareholders are ascribing no value to the firm’s prop businesses, which are now collected under the “Investing & Lending” heading. That’s despite commanding the highest pre-tax margin of any business line at the firm — almost 50 percent. This valuation also ignores a collection of investments that Goldman reckons are currently worth some $15 billion.

It’s reasonable for investors to be cautious about proprietary risk-taking. And client trading can cause losses, too, as Goldman discovered last spring. Being deemed worthless may be a blow to the unit’s ego. But it serves Goldman’s purpose well. Even if the new regulation known as the Volcker Rule were to kill off all its prop activities, the firm’s stock shouldn’t take a hit: it’s already trading at around fair value. That’s fodder for a bullish view of Goldman’s shares.

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