Goldman Sachs (GS, Financial) led second-quarter big bank earnings results, outperforming in four of five major categories and falling just below Morgan Stanley (MS, Financial) in the final trading revenue category, where it reported comparable quarter growth of 16% versus the top 19%.
Source: Wall Street Journal
The strong second-quarter results provide some interesting insights through the peer group analysis and present a compelling case for the stock’s alpha potential. As such, investors weighing options for financial sector exposure will find the following argument details why Goldman Sachs is currently a top choice for superior alpha generation among the big banks.
Return expectations
Across the big banks, Goldman Sachs’ stock is by far the most expensive at $234. As of July 23, its stock price is twice that of JPMorgan’s (JPM, Financial) and nearly eight times the lowest ranging value in Bank of America (BAC, Financial). At $234, it makes diligence even more critical when comparing to other big banks. Thus, a look at potential estimates across the small sample helps to confirm the validity of the future prospect. Analysts are showing Goldman Sachs with high potential to be the top performer of the big banks over the next year and the company’s outstanding second-quarter earnings could propel it to the top of the selection list. On a one-year basis, analysts are calling for an 18% potential return, which matches the return expectations of Morgan Stanley and falls just below the 20% upside projection for Citigroup (C, Financial).
*Analysts' estimates from Yahoo Finance
Improving net interest margins and a revival in trading revenue has helped the banking sector to gain attention. It appears after the second-quarter results that Goldman Sachs could be the group’s outperformer in these catalyst areas. The stock price is down slightly after a year-to-date return of -8.45%, which in this case could provide greater strength for an alpha signal. Goldman Sachs has reported the worst year-to-date return as of July, but returns for Morgan Stanley, Citigroup and Wells Fargo (WFC, Financial) have all also been lower. Three-year returns are showing the average beta across the group at 1.40 and with the S&P 500 returning 5.70%, it appears the lows are just a bit of a dip.
Source: Morningstar
Across the financial sector, year-to-date returns reflect some pullback from concerns over the economy’s growth and future rate increases, given the changing international tariff environment. Financials have taken a harder hit year to date than other sectors because of the greater correlations among rate policy, the economy’s growth, inflation and tariffs. As such, the three-year group beta suggests financials should recover. However, current price-earnings ratios across the group suggest that the improvements will be moderate with trailing to forward price-earnings levels down an average of 30% across the group. Generally, given the three-year betas, it appears all of the year-to-date performance figures could also reflect some of the movement out of equities in a risk off trading environment rather than underlying intrinsic value movements as it seems the Federal Reserve is likely to continue with two more rate increases in 2018 and the effects of inflation and gross domestic product are far to be seen.
Source: Morningstar
Revenue
With an already positive outlook, the quarterly earnings report from Goldman Sachs only enriches the value potential and improves the alpha outlook in comparison to its large bank peers. Total revenue for the quarter came in at $9.4 billion, increasing 19% from the comparable quarter and decreasing 6% from the first quarter. Revenue growth was led by Investing and Lending, where the bank has added lending platform Marcus. In the Investing and Lending category, revenue grew 67% from the second quarter of 2017, with $663 million in debt securities and loans versus $396 million in the comparable quarter. The second quarter’s results followed a strong first quarter that reported $1.02 billion in debt securities and loans. Marcus is expected to continue as a growth catalyst. As the branding initiative continues, the platform also has the potential to benefit significantly from the rising rate environment as the new lending business offers loans to a broad array of consumers in the U.S.
Second in the total trading revenue growth category, Goldman Sachs saw total trading revenue of $3.60 billion across five trading segments. Fixed Income, Currency and Commodities (FICC) Client Execution increased 45% to $1.7 billion. Total equity trading revenue was basically unchanged at $1.91 billion versus $1.92 billion in the comparable quarter.
Over the last year, data from Morningstar as of the first quarter of 2018 shows Goldman Sachs just trailing Morgan Stanley in the one-year revenue growth category with one-year revenue growth of 5.28%. Across the banking group, Goldman Sachs is also showing upside potential with a price-sales ratio of 2.57 versus the group average of 3.17. Over the past four years, revenue per share growth has also been trending higher at a rate of 5.32%. In 2018, bullish analysts are expecting revenue growth of 18%, further supporting the upside revenue trend.
Earnings
Goldman Sachs led the big banks in net profit and earnings per share gains. Earnings per share were $5.98, increasing 51% from the comparable quarter and decreasing 14% from the first quarter. Earnings per share has been volatile as the company has been buying back shares. For the past four years, earnings per share growth has averaged 1% while shares outstanding have decreased an average of -4.55%.
In the second quarter of 2018, net earnings increased 40% (44% with rounding) from the comparable quarter and decreased 9% from the previous quarter. Earnings before interest, taxes, depreciation and amortization and EBIT have been trending higher over the past three years. EBITDA has averaged $22.6 billion with an average annual growth rate of 21%. EBIT has averaged $21.4 billion with an average annual growth rate of 22%. In the second quarter, results showed pre-tax earnings increasing 31% from the comparable quarter. Analysts have an estimate of $27.02 for earnings per share in 2018, representing a forward earnings growth rate of 37% and further supporting continued moves higher in earnings, EBITDA and EBIT in the near term.
Alpha opportunity
Overall, after the second-quarter outperformance it seems the alpha opportunity is even more compelling for Goldman Sachs in comparison to its large bank peers, making the stock a top investment for investors looking for large bank exposure.
Goldman Sachs led the return on equity category for the banks with a 47% increase to a ROE of 12.80%. Total shareholders’ equity has averaged $85.4 billion over the past three years.
Goldman Sachs is also reporting a forward dividend yield of 1.38%. The trailing 12 months show a dividend of $3.23 with a one-year dividend growth rate of 11.54%.
Price-earnings valuation
Taking the high end of analysts’ guidance for earnings per share in 2018, Goldman Sachs has the potential to increase to approximately $585 at its current price to earnings level of 21.66. Projections for the forward price-earnings are estimated at 10.05, which would give it a value of approximately $272 with a conservative upside of 16% or $38.
DCF
Discounted cash flow is difficult to define for the company since it has been operating with volatile free cash flow, ranging from -$20.9 billion to $7.7 billion, over the past four years. The DCF valuation assumes positive free cash flows for ten years. Other basic assumptions for the DCF valuation include the following:
- Weighted average cost of capital: 4.56%
- Terminal growth: 3.00%
With these assumptions, the stock has a DCF of $300 with upside of 28%.
Disclosure: I do not directly own any shares of any stocks included in this article.
