Goldman Sachs is significantly leveraged to rising interest rates

Business Strategy & Outlook

Goldman Sachs has made progress on the strategic plan that it laid out at the beginning of 2020 and set even more ambitious goals in 2022. The company is now targeting a medium-term return on tangible equity of 15% to 17% compared with a previous goal of over 14%. In addition to the ROTE target, management also set an expense ratio goal of about 60% and growth targets for its asset management and consumer banking businesses. While one cannot be sure the company will hit all of those goals over the next three years, the company will exceed a 15% ROTE in the long run after its consumer business has reached a more profitable scale. Goldman Sachs’ trading business also remains a large swing factor, as it requires more capital and tends to have lower operating margins than the other business segments. COVID-19 boosted revenue in 2020 and 2021 with high trading caused by economic uncertainty and companies issuing debt and equity to initially bolster capital and then later issuing debt and equity to take advantage of low interest rates and a strong stock market. Net revenue should retrace somewhat in 2022 and 2023 from the unusually strong 2021 level, and as per forecast 2023 revenue to be about $45 to $50 billion compared with nearly $60 billion in 2021.

As per given forecast, the firm should trade at 1.5 to 1.6 times tangible book value. Its investment management business has become a priority. Assets under supervision exceeded $2.4 trillion at the end of 2021, while related investment management fees have been around 15%-20% of net revenue compared with 11%-12% before 2008. Investment management is a relatively stable, high-return-on-capital business that is well suited to the current regulatory environment. Goldman has also built out a large virtual bank and had deposits of $350 billion at the end of 2021 compared with $39 billion in 2009. The deposit base and related net interest income will add more stability to the company’s revenue stream and balance sheet in the medium term. Goldman Sachs is significantly leveraged to rising interest rates, so its valuation shouldn’t be as affected as peers by the current uncertainty over inflation and interest rates.

Financial Strengths

The long-run gross leverage of 11-13 times. This is below pre-credit-crisis levels of above 25 times. Although Goldman remains highly leveraged, it has restructured as a bank holding company, and its access to government borrowing facilities decreases its short-term funding concerns. The balance sheet is also much cleaner now than before the recession and has a high amount of excess liquid securities. Recently, level 3 assets that are valued using inputs that are significant and unobservable were about 20%-25% of common equity compared with over 100% in 2008. Although you don’t have any immediate concerns in terms of solvency or liquidity, an investment bank’s financial health can turn rapidly for the worse if counterparties experience a crisis of confidence. Goldman Sachs’ regulatory capital ratios are healthy. At the end of 2021, the company had a 14.2% common equity Tier 1 capital ratio. The company targets a common equity Tier 1 ratio of 50 to 100 basis points above its requirements. This would currently equate to a common equity Tier 1 ratio of slightly over 14%, but a longer-term target of 13.50%-14.00%. All of Goldman’s capital ratios are well in excess of regulatory minimums. The company’s ability to return capital is determined by the Federal Reserve Board’s annual Comprehensive Capital Analysis and Review.

Bulls Say

More-stable investment management and net interest income could cause investors to reassess Goldman’s earnings quality and increase their willingness to pay a premium for it.

The company’s trading operations can potentially do well in recessions and periods of economic uncertainty, which can buffer earnings.

Several of the company’s primary U.S. and European competitors have been forced to restructure, which could give Goldman an opportunity to gain market share.

Company Description

Goldman Sachs is a leading global investment banking firm whose activities are organized into investment banking (20% of net revenue), global markets (45%), asset management (20%), and consumer and wealth management (15%) segments. Approximately 60% of the company’s net revenue is generated in the Americas, 15% in Asia, and 25% in Europe, the Middle East, and Africa. In 2008, Goldman reorganized itself as a financial holding company regulated by the Federal Reserve System.

(Source: Morningstar)

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