Friday, 30 April 2010 12:56

Can You Believe There Are Still Analysts Arguing How Undervalued Goldman Sachs Is? Those July 150 Puts Say Otherwise, Let's Take a Look

To begin with , Goldman Sachs produces more accounting revenue and accounting profits than its peers. This is because Goldman benefits from virtual monopoly pricing and advantages in several markets. Despite this advantage, when one factors in economic RISK and the cost of capital, Goldman doesn't fare nearly as well as the sell side makes it seem. Of course, the sell side rarely attempts to quantify risk, which is cool until reality rears its (sometimes ugly) head. Before we get to risk adjust returns, let's look at the simple accounting numbers and attempt to throw some logic on them...

I bank mutliples

Above, you see that GS has enjoyed a significant premium over its peers in terms of book valuation. This premium has actually increased over the past year. Let me be the one to remind you that no US company has every survived a criminal judgment, none. Arther Anderson was driven into bankruptcy from charges stemming from the Enron collapse, and that is despite the fact that the Supreme Court overturned the guilty verdict! Assuming, for the benefit of the doubt, GS can somehow set precedence, or more realistically, criminal charges are not filed, we still have to contend with:

  1. the SEC lawsuit
  2. the increased regulation, in particular the Volcker rule and derivatives oversight
  3. follow on litigation, which is virtually guaranteed, and virtually guaranteed to be extremely expensive, time consuming, and distracting from the core businesses.
  4. a general decline in business since we are coming off of a credit and risky asset boom and going into a sovereign debt crisis that will make FICC much less predictable (seeThe Next Step in the Bank Implosion Cycle??? for a more on how this could end with the Pan-European Sovereign Debt Crisisdrama unfolding).

Taking all of this into consideration, you tell me... Does Goldman really deserve to be trading at such a premium considering the myriad risks it is currently exposed to PLUS the murky business and regulatory environment? They are also losing talent on the sales side, and at the MD level to boot. Today's market is starting to see things the Reggie Middleton way.

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Now, let's factor in some more reality. No matter what your broker says about accounting earnings and revenues, they don't come free. They all have a cost of capital attached to them. Let's reference an excerpt from When the Patina Fades… The Rise and Fall of Goldman Sachs???

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.

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Remember, practically everybody poo-poohed my research and opinion in 2008 when I said Goldman was drastically overvalued - Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis. Those 600% to 1000% gains on the put options proved otherwise. Speaking of which, those July 150 puts... Can you smell what the forensic analysis is cookin'???

gs July 159 puts on 4-30-10

For those who haven't read my review of Goldman's latest quarter performance, please do: A Realistic View of Goldman Sachs and Their Latest Quarterly Results

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Last modified on Thursday, 14 July 2011 03:25

7 comments

  • Comment Link Reggie Middleton Wednesday, 12 May 2010 03:07 posted by Reggie Middleton

    First goldman, now Morgan Stanley?
    U.S. Investigates Morgan Stanley Deals

    U.S. prosecutors are investigating whether Morgan Stanley misled investors about mortgage-derivatives deals it helped design and sometimes bet against, in a step that intensifies Washington's scrutiny of Wall Street.
    http://online.wsj.com/article/SB10001424052748704250104575238680672738838.html?mod=WSJ_hps_LEFTTopStories

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  • Comment Link winks Monday, 03 May 2010 16:48 posted by winks

    Shy, you are not.

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  • Comment Link Reggie Middleton Monday, 03 May 2010 10:48 posted by Reggie Middleton

    @ Wade, I don't have the data from February, but the puts were $3 about a month ago, versus $15 Friday.

    @ Winks, This is a blog about my opinion and analysis - both right and wrong. Expect to hear more of the same. Practically no one was bearish on Goldman, which goes to show that many were looking at name brand vs the numbers, macro outlook and the political environment. I am not shy about point that out, particularly considering the flack that I got about being bearish on them in the first place.

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  • Comment Link winks Saturday, 01 May 2010 22:56 posted by winks

    I would find your work more palatable if you weren't constantly telling us how you were the only one who "saw the truth" way before anyone else. Try writing a piece and leave comments about yourself out of it.

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  • Comment Link wade Saturday, 01 May 2010 18:49 posted by wade

    Just out of curiosity, what where they going for back in Feb? I have a straight short on GS from last year at $120 so I still have a ways to go for profitablity -- I'm hanging in there!

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  • Comment Link Reggie Middleton Saturday, 01 May 2010 10:30 posted by Reggie Middleton

    Well, they are awfully high if you don't think GS will drop significantly. In addition, it is good that they are awfully high to those who bought them in February when I came out the with the refreshed valuation, right after several explicit warnings that GS was playing with fire in terms of the administration and the regulatory environment.

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  • Comment Link hmc Saturday, 01 May 2010 09:50 posted by hmc

    Would you buy those GS $150 July PUTS at $15.50? That seems awfully high!

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