Goldman Sachs: Undervalued Stock, A Smart Option Play (NYSE:GS) (2024)

Goldman Sachs: An appealing market setup

With its famous and prestigious name, Goldman Sachs (NYSE:GS) is definitely one of the most known banks in the world. In many decades of activity, it built a durable competitive advantage thanks to its ability to attract talent from the best universities. The strong economic recovery after Covid-19 helped GS to deliver incredible results in terms of earnings and ROE, but the market is expecting a substantial slowdown in the following months. While it is true that a big slice of earnings came from incredibly high trading results in the first quarter, an up-rise in volatility along with other factors could surprise the market. Again, by implementing an ad-hoc model with very conservative assumptions about the future, Goldman is moderately undervalued by about 25%. This interesting setup, along with cheap options could generate fat returns for investors willing to be patient 2-4 months from now, as results will be published.

Is this the Apple of Investment banking?

Goldman is a very prestigious name that has been built in many decades of superior performance and the important skill of attracting new and motivated talent. Young people coming from the best universities around the world try to join this bank, and while IB is not the most favorite place of Harvard guys, their acceptance rate is still below 10%. This allows GS to have some of the most brilliant guys from different academics backgrounds working for a single purpose: making tons of money and not taking too much risk by doing so (yes, Risk Management is the key after 2008). Thanks to this competitive advantage they are reporting strong results in alternative divisions, such as equity investments. In the first 6 months of 2021 GS reported about $5.8 billion in revenues from Private Equity investments, against the mere $500 million a year ago. It's a growth of more than 1000% that had a very positive impact on overall revenues, which stand at $30 billion (thus PE accounted for 17% of total revenues). A short history of intense volatility on the markets, following the Covid-19 pandemic, showed that they have been capable of taking advantage of these tailwinds and making fat gains in MM activities. As both traders and liquidity providers on the market, they realized strong results because of the big swings that took place after March 2020 and for the rest of the year as well. The VIX index is still at a considerably higher level than 2019, so it's important to note that GS is still in the perfect position to take advantage of a tough fall and winter (in terms of turbulent markets). The last two years demonstrated that these big players are a great way to profit in tough periods because of their great flexibility (much better than in the past) in adapting to a new market and make money in bullish and bearish scenarios.

Q3 and Q4 will be the key to a re-rate, but even if GS does not beat them it's still super cheap

Currently, the valuation multiples on GS are extremely low, especially if compared to other big names like JPM and MS.

(Source: SA charting on Goldman Sachs)

This happens because the market is expecting a big cut in terms of revenues and earnings in Q3 and Q4, following a return to normal equity markets. The expected EPS for 2021 is about $53. Considering that the cumulative EPS for Q1 and Q2 is $33, it means that GS is expected to gain, on average, $10 EPS in both the next quarters. In 2020 they outperformed that result and with a turbulent fall in the treasuries market, I expect the bank to outperform in the trading division also in 2021. This will lead to an EPS of about $58-$60 and an implied P/E (FWD) of 6(!). Considering that similar players like Morgan Stanley are trading at a P/E of 13, the upside potential seems really high. In the last 5 quarters, the company beat the expectations by many percentage points.

(Source: SA section on GS Earnings)

The probability of seeing higher earnings is really high, especially because of turbulent equity and bond markets (VIX and 2021 highs) and strong economic recovery (that could fuel IB division's earnings). But besides all this, the stock is cheap even without a surprise. The current implied multiple with the 2021 EPS estimates is a P/E of 7. This means that a random event could trigger a strong re-rate in case the company is suspected of continued success even after 2021 with great results (highly probable).

Giving a fair price to a super-complex financial institution: an unconventional approach

Giving a fair price to such a super-complex financial institution is not an easy game. They have different divisions with different economics that make the overall approach very difficult even for seasoned analysts. Trying to reduce all this to a mere P/B or P/E seems too much of an oversimplification to me. A different approach will be implemented. I will use a non-conventional model that uses FCFE as an input instead of FCF (basically the DCF model for financial firms). FCFE is "Free Cash Flow to Equity", which is calculated by subtracting changes in equity and adding back comprehensive income to net earnings. This allows to adjust for regulatory requirements' impact and thus discount back to the present only the "free" earnings, that are not required to be retained. This sounds like a Dividend Discount Model but it is meant to "catch" also the non-distributed cash that can be held by the bank.

To forecast the changes in equity, a growth rate in RWA (Risk-Weighted Assets) is assumed at 4% per year. The capital requirements are an Equity/RWA of 12% (or about a CET1 above 10%). To stay conservative and to reflect a significant return to normal in the next year, the 2022 earnings are expected to be about $13 billion, instead of the 2021E $18 billion. Discount rate at 8%, higher than the WACC, always to be more conservatives. The final result is a fair price of $415, with an implied potential of about 10% (remember, the model is very conservative). At the same time, if we consider a P/E of 10 (average between the current multiple and the competitors' one), the fair price would be $530, considering the current estimates for 2021. The average fair price at this point is $470, with an implied upside potential of 24%.

The best way to play this game: cheap leverage with cheap options

Since the upside potential is not big, a better way to invest and profit from this modest undervaluation is through options. GS's options are quite cheap and by betting on the 6 to 9 months expirations the reward can easily triple. For example, the March 2022 calls (6 months) are trading at very interesting prices.

(Source: GS March 2022 Call Options Yahoo Finance)

To buy the March 18, 2022 ATM Call option the premium paid would be $28 (average between bid price of $27.4 and ask price of $28.6), or about 7% of the nominal stock price. The leverage acquired, adjusted for the options' delta, would be about 7.5 (1/7% x 0.52, where the latter is the delta). The position will then break even at $408 (without even considering time value) and every cent after that price through $470 (target price) is pure profit. Hypothetically, the potential profit is $62 per option, with an overall implied return of 220% (from the $28 premium). Of course, time is everything and if the stock starts re-rate after March 2022 the investment will be worth $0, aka loss of 100%, but this is how options work.

Conclusion

Goldman Sachs is really a great financial company able to attract talent and deliver superior results. Currently, the market is underestimating its potential both in the short term (next quarters) but also over a longer time frame (they are betting on much lower earnings in the next years). Since the overall undervaluation is modest, risky options offer a very appealing risk/reward play that could surprise investors with strong returns.

Student focused on fundamental analysis and deep value investing. I like looking for asymmetrical opportunities, "Heads I win, tails I don't lose that much". Interested in event-driven situations, spinoffs, mergers, and litigations.