FINC 440 Valuation of Goldman Sachs PDF

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1 RUNNING HEAD: VALUATION OF GOLDMAN SACHS GROUP, INC.

Valuation of Goldman Sachs Group, Inc. LaMario Cato FINC 440: Security Analysis and Valuation UMUC: Professor Buettner Submission Date: December 16, 2018

2 VALUATION OF GOLDMAN SACHS GROUP, INC Introduction The Goldman Sachs Group, Inc. (GS) was founded in New York in 1869 by Marcus Goldman. GS is a leading global investment banking, securities, and investment management firm that provides a wide variety of financial services to a substantial and diverse client base, including corporations, financial institutions, governments and individuals (Goldman Sachs, n.d.). Services include strategic advisory assignments with respect to mergers and acquisitions, divestitures, corporate defense activities, restructuring, spin-offs and risk management, and debt and equity underwriting of public offerings and private placements. This paper will look to assess Goldman Sachs based on specific valuation methods, using information from the company’s financial reports, such as GS SEC 10K, Morningstar Financials and Yahoo! Finance. The three valuation measures used to value GS are the Dividend Discount Model (DDM), Valuation by Comparable, and the Excess Returns Model. The paper will provide an explanation of principal assumptions used in the DDM, an analysis on whether or not the valuations are consistent, and any special challenges that arose while conducting the analysis. In addition, a comparison of each stock price based on the current price and the computed stock value will be provided and explained. Analysis Section This section will describe each valuation method used to value Goldman Sachs, beginning with the Dividend Discount Model, followed by the Valuation by comparable and finally the Excess Return Model. Dividend Discount Model Valuation

3 VALUATION OF GOLDMAN SACHS GROUP, INC The Dividend Discount Model generally understates the intrinsic value of the firm but can be a worthwhile tool for equity valuation. Financial theory states that the value of a stock is the worth of all future cash flows expected to be generated by the firm discounted back by an appropriate risk-adjusted rate (Vecchio, 2000). This helps provide a measure Goldman Sachs cash flows using two DDM's valuation techniques; the Constant Growth Model and the Variable Growth Model.

A. Constant Growth Model The constant growth model uses caveats and assumptions that must be understood. The required rate of return was calculated by calculating the rate of return based on CAPM and DDM and calculating the average. The CAPM rate of return is calculated using Goldman Sachs current beta of 1.02, the 10-year treasury bond rate of 3.50%, and a market risk premium of 5.00%. Using this information, the formula R = Treasury bond plus beta times market risk premium calculates a CAPM rate of return of 8.60%. The Dividend Discount Model rate of return is calculated using the last dividend & stock repurchase per share of $4.77, the current stock price of $179.67, and an expected growth rate of 3.23%. With this information using the formula K = D1 / P0) +G; where D1 is the last dividend*(1+geometric mean of annual rates), P0 is the stock price, and g is the expected growth rate, the estimated required rate of return is 5.97%. Using these two inputs, the constant growth models required rate of return is 7.28%. The constant growth models principal assumptions are that Goldman Sachs dividends will remain consistent at $4.77, the required rate of return is 7.28%, and an expected annual growth rate is 2.50%. Using the formula p0 = d1 / (k – g); where d1 is the last stock repurchase payment

4 VALUATION OF GOLDMAN SACHS GROUP, INC per share times 1 plus the expected annual growth rate, k is the required rate of return and g is the expected annual growth, Goldman Sachs intrinsic stock value is $102.12. Goldman Sachs intrinsic stock value based on the constant growth model will differ from the value based on the variable growth model because the variable growth model assumes dividends will increase year-over-year. B. Variable Growth Model The variable growth models principal assumption is that Goldman Sachs dividends will begin at $4.77 and increase constantly over a 5 year period based on the following expected growth rates; 3.80% in 2018, 3.80% in 2019, 3.25% in 2020, 3.00% in 2021 and 2.50% in the terminal year 2022. Using these assumptions, Goldman Sachs will pay dividends of $4.95 in 2018, $5.14 in 2019, $5.30 in 2020, $5.46 in 2021, and $5.60 in 2022. These figures estimate Goldman Sachs stock price to be $117.01 in 2021, which is calculated by dividing the expected 2022 dividends by the required rate of return of 7.28% minus the expected annual growth rate in 2022. The model then estimates Goldman Sachs non-discounted cash flows based on the expected dividends payout and calculates the non-discounted cash flows through 2021. The calculations predict GS 2021 stock value will be $122.47. The 2021 stock price is then discounted back to the present value to determine Goldman Sachs intrinsic stock value based on the variable growth model, which calculates to $105.81. Excel uses the NPV formula based on the non-discounted cash flows to calculate this stock value. Comparing both values to the current market price of $179.67 (as of 12/09/18 Yahoo! Finance), it seems that Goldman Sachs stock price is significantly overvalued, which may mean the stock’s price will drop in the future. Comparing the figures to the current book value per

5 VALUATION OF GOLDMAN SACHS GROUP, INC share value of $197.33 further proves that this stock may be overvalued. Evaluating the value per share based on the Valuation by Comparable Method will provide better insight as to how valuable Goldman Sachs stocks are in relation to the stocks intrinsic value. Valuation by Comparables The Valuation by Comparables measures Goldman Sachs performance by comparing ratios such as the Price-to-Earnings, Price-to-Book, Price-to-Sales, and Price-to-Cash Flows, to five main competitors, Wells Fargo, JP Morgan Chase, Bank of America, Morgan Stanley, and US Bancorp, in an effort to reach benchmark values, which will be used for the valuation of GS stock. The benchmark value is determined by calculating the industry average, mean, max and min of the above ratios and multiplying it by the expected dividend payout of $4.77. Based on this information, the Valuation of Comparables calculates an expected stock value of $128.28. This value is then compared to the actual market value of the stock. Based on the intrinsic value being lower than the market value, it is safe to conclude that GS stock is overvalued based on the Valuation by Comparables (Investopedia, 2018). It is important to remember that this valuation is based on firms with similar market capitalizations and valuations. The valuation is also based on the expectation that dividends will remain constant, and ratios within each firm will neither increase nor decrease. Due to Goldman Sachs stock being relatively higher than all firms in the respected sector, it is safe to conclude that the stock’s value is skewed by the competitors stock value. In comparison, Goldman Sachs stock value is above the average value of the five firms, and the Price-to-Earnings and Price-toCash ratio is significantly higher than the industry average. The next section will calculate Goldman Sachs stock value based on the Excess Return Model.

6 VALUATION OF GOLDMAN SACHS GROUP, INC Excess Returns Model In the Excess Returns Model, the value of a firm can be written as the sum of capital invested currently in the firm and the present value of excess returns that the firm expects to make in the future (Damodaran, 2009). There are two inputs needed to value equity in this model; a measure of equity capital currently invested in the firm and the expected excess returns to equity in future periods. The equity capital was measured by Goldman Sachs book value of equity, which according to Goldman Sachs Form 10K, is $70,390.00 billion. This number is identical to the number used for GS book value of equity invested currently and the valuation is based on a 5 year period. In addition to the figures above, Goldman Sachs value can be calculated with the current cost of equity. Using the average beta of 1.02, reported by Yahoo! Finance, in conjunction with a treasury bond rate of 3.50% and an equity excess return premium of 5.00%, Goldman Sachs cost of equity calculates to 8.60% and the return on equity calculates to 10.51%. Assuming that the return on equity will remain constant at 10.51%, the model calculates Goldman Sachs net income each year; by multiplying the return on equity each year by the beginning book value of equity, then augmenting the book value of equity by a portion of earnings that is not paid out as dividends (Damodaran, 2009). Appendix D shows the calculations in more detail. To put a closure on this valuation, assumptions about the excess returns must be made. Based on the assumption that the company's beta will remain 1.02, the risk-free rate will stay consistent at 3.50%, and the number of shares outstanding will remain 371.97 (million), Goldman Sachs value per share based on the Excess Returns Model is $206.05. This number is

7 VALUATION OF GOLDMAN SACHS GROUP, INC slightly higher than the current share price of $179.67, which is an indication that Goldman Sachs stock is currently undervalued. Are the Valuations Consistent? The valuation results of the three valuation models are shown in the following table: Valuation Model DDM – Constant Growth DDM – Variable Growth Valuation By Comparables Damodaran’s Excess Returns Current Market Price

Stock Value $102.12 $105.81 $128.28 $206.05 $179.67

The valuation calculations, as shown in the above table, prove to be inconsistent. The DDM, both constant ($102,12) and variable ($105.81), and valuation by comparable calculate a stock value lower than the current stock price of $179.69, which implies that Goldman Sachs stock is currently overvalued. The Excess Returns Model ($206.05) implies the opposite, as this model generates a stock value higher than the current market price. The difference in price can be attributed to the different measurements and assumptions used in the valuation models. The difficulty is determining which model is appropriate, or which model should be used in justifying whether or not the stock is valued appropriately. The challenges encountered within the valuations came mainly from the assumptions. In the excess returns model, it is up to the analyst using the model to forecast not only where the financial service firm will direct its future investments but also the returns it will make on the investment (Damodaran, 2000). Calculating this was rather challenging, as different assumptions caused the stock to rise/fall. The Valuation of Comparables was the most challenging model to use. For starters, a comparable company, based on Goldman Sachs current

8 VALUATION OF GOLDMAN SACHS GROUP, INC stock value, does not exist. With GS stock value being significantly higher, it became challenging to manipulate the data in a fashion that provided an accurate valuation based on the industry average. For this reason, a calculation of the mean, median, minimum and maximum ratio valuation was conducted. This, however, still does not depict an accurate representation of the stock’s value due to the market capitalization and stock value being drastically higher in comparison to the respected industry. The Dividend Discount Model was the easiest valuation model, however, there were still slight challenges in assuming the anticipated growth rate through the terminal year. Ultimately, the growth rates were based on the banking industries expect growth rate. From a financial perspective in relation to the specific valuations, challenges based on disadvantages emerged. The validity of the Dividend Discount Model can be questioned based on the number of assumptions. For. This reason, challenges arose in regards to calculating the expected dividends, interest rates, and tax rates. In spite of the challenges, the Excess Return Model seems to be the most accurate, as it provides the closest depiction of Goldman Sachs current stock price. Although it is slightly higher, when comparing the actual value and the book value per share value, this number seemed most appropriate. Summary/Conclusion Using information from Yahoo! Finance, Market Watch, and Goldman Sachs Form 10-K, the valuations were able to calculate Goldman Sachs intrinsic stock value. The different valuations led to different results, both higher and lower than the current stock price. The dividend discount model calculated the stock value lower than the current price by more than $75, while the excess return model calculated a value slightly above. Overall, the valuation that

9 VALUATION OF GOLDMAN SACHS GROUP, INC is considered to be the most appropriate is the Excess Return Model, which calculated a value relatively close to the current market price. Although the calculations provide mixed messages, it is safe to conclude that Goldman Sachs stock is slightly undervalued when comparing the price against this model. With Goldman Sachs being one of the leading banks in the banking industry, it is hard to believe that the stock’s value is significantly lower than the market price.

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References Damodaran, A. (2009) Valuing Financial Service Firms. Retrieved from http://people.stern.nyu.edu/adamodar/pdfiles/papers/finfirm09.pdf Form 10K. (2017) The Goldman Sachs Group, Inc. Form 10-K. Retrieved from https://www.goldmansachs.com/investor-relations/financials/current/10k/2017-10k.pdf Goldman Sachs. (n.d.) At A Glance. The Goldman Sachs Group, Inc. Retrieved from https://www.goldmansachs.com/who-we-are/at-a-glance/index.html Investopedia. (n.d.) Comparable Company Analysis – CCAA. Retrieved from https://www.investopedia.com/terms/c/comparable-company-analysis-cca.asp Market Watch. (2018) Company Valuation; Goldman Sachs, Wells Fargo, JP Morgan Chase, Bank of America, Morgan Stanley, and US Bancorp. Retrieved from https://www.marketwatch.com/investing/stock/usb/profile Vecchio, J. D. (2000) Dividend Discount Model. The Little Book. Of Valuation. Retrieved from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/ddm.htm Yahoo! Finance. (2018). The Goldman Sachs Group, Inc. (GS). Retrieved from https://finance.yahoo.com/quote/GS/key-statistics?p=GS

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Appendix Appendix A. Dividend Discount Model Inputs

Appendix B. Stock Price – Constant Growth model

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Appendix C. Stock Price – Variable growth Model

Appendix D. Excess Returns Model

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