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Stock Valuation: The Case of Goldman Sachs
Author: Yao Yao(姚峣)(firstname.lastname@example.org)
Norwegian School of Economics(NHH)
SSRN index:( http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=357301)
Goldman Sachs Group (NYSE stock ticker: GS) is one of the leading investment banks and a
Fortune 500 firm, with its IPO in 1999. In this paper, we will present a detailed stock analysis
on GS stock.
Our paper will focus on two aspects:
1. Illustrate investment banking industry competition drivers.
2. Value GS stock with three methods: Dividends Discount Model (DDM), Price/Earning
Multiple and Residual income method.
1. Introduction....................................................................................................Page 4
2. Investment Banking Industry Overview.....................................................Page 5
2.1 Industry Overview...............................................................................Page 5
2.1.1 Business Segments in Investment Banking...............................Page 5
2.1.2 Industry Trends ..........................................................................Page 6
2.2 Competition drivers in Investment Banking Industry......................Page 8
3. Goldman Sachs Group Overview..................................................................Page 13
3.1 Goldman Sachs Group Information...................................................Page 13
3.2. Strategic analysis on GS......................................................................Page 14
4. Financial Analysis on Goldman Sachs...........................................................Page 18
5. Risks Analysis on Goldman Sachs.................................................................Page 23
6. GS Valuation Ratios .......................................................................................Page 25
7. Valuation .........................................................................................................Page 34
7.1 Review of Valuation Theory................................................................Page 34
7.2. What is unique about investment bank valuation? .........................Page 35
7.3. Price Multiples Valuation...................................................................Page 38
7.4. Residual Income Valuation Method..................................................Page 40
8. Summary..........................................................................................................Page 41
Attachment 1: 2002 Investment Banking League Table...................................Page 42
Attachment 2: Investment Banking Business in 2002 .......................................Page 46
Attachment 3: GS Management Team Profile...................................................Page 50
Attachment 4: Goldman Sachs IPO in 1999........................................................Page 53
Attachment 5: Selected GS financial Statements................................................Page 55
Charts in Main Text
Chart 1: Major Trend--Consolidation..................................................................Page 7
Chart 2: Segments Trends Analysis.......................................................................Page 8
Chart 3: ROE of Industry Leaders........................................................................Page 8
Chart 4: Major Cost Driver--Salary......................................................................Page 10
Chart 5: GS Common-Size Income Statement .....................................................Page 18
Chart 6: GS Five-Year Stock Chart.......................................................................Page 25
Chart 7: GS Valuation Ratios on July 11, 2003....................................................Page 26
1.1 Problem Area and Objective
This paper is mainly to achieve two aims: 1. present industry analysis on investment banking
business; 2. value Goldman Sachs stock through different methods.
1.2 Structure of the Paper
The paper is consisted of eight parts. Part one is introduction. In part two we make a general
review on I-banking industry. In part three we present the profile of Goldman Sachs Group.
Then in part four we will analyse GS financial data , based on its latest annual reports. In part
five, we will briefly list business risks for GS. In part six we compare fundamental valuation
ratios of three biggest investment banks. In part seven we present relevant valuation theory
and then value Goldman Sachs stock through three methods: Dividend Discount Model , Price
multiples and a simple Residual Income Model. As a final step, in the eighth part we draw a
general conclusion of the paper.
The paper is a result of desk-based study. To write the paper we will resort to the materials
and information that are available in public media about Goldman Sachs and investment
banking industry. We will combine these materials and information with the theories in the
fields of competitive strategy and corporate valuation.
2. Investment Banking Industry Overview
Goldman Sachs is a leading investment bank and a Fortune 500 firm. Before analysing its
stock value, we’d like to explore into the mysterious investment banking industry. We will
review industry trends and competition drivers in the following.
2.1 Industry Overview
Investment banking is the business of raising capital or trading for customers. It is a cyclical
and mature industry, with fierce competition among global players. Companies need cash in
order to grow and expand their businesses; investment banks are firms who sell securities to
public investors in order to raise this cash. These securities can come in the form of stocks or
bonds. Besides, investment banks also provide hedging tools for customers.
2.1.1 Business Segments in Investment Banking
a. Corporate Finance
Corporate finance is a traditional I-banking business, including two functions: 1. Mergers and
acquisitions advisory; 2. Underwriting. On M&A business, bankers assist in structuring a
merger between two companies. As to the underwriting function, I-banks raise capital for a
company by selling either stocks or bonds to investors.
Sales-people can be divided into different categories: retail broker, institutional salesperson,
and private client service representative. Brokers contact with individual investors and sell
stocks altogether with investment advice. Institutional salespeople focus on large institutional
investors. Institutional investors are those who manage large groups of assets, such as pension
funds or mutual funds. Private Client Service representatives provide brokerage and money
management services for extremely wealthy individuals. All salespeople make money through
commissions on trades made through their firms.
Traders usually carry an inventory of securities for sale or trade for a client, providing
liquidity for the market. Traders make money by purchasing securities and selling them at a
Research analysts usually write reports about certain stocks and bonds, making suggestions on
those securities. Stock analysts usually focus on one industry and will cover up to 20
companies' stocks. Salespeople depend on research analysts to convince their clients.
Corporate finance bankers rely on research analysts to be experts in the industry in which they
are working. Top research analysts can generate lots of corporate finance business as well as
substantial trading activity.
Syndicate is a link between salespeople and corporate finance, facilitating the placing of
securities in a public offering. In a corporate or municipal debt deal, syndicate also determines
the allocation of bonds.
2.1.2 Industry Trends
Leading investment banks include Goldman Sachs, Merrill Lynch, Morgan Stanley Dean
Witter, CSFB , J.P. Morgan and Lehman Brothers, etc. Goldman Sachs is deemed the King of
global IPO and M&A advisory. Merrill Lynch ranks top in global debts underwriting and
Nowadays, three powerful forces are driving this competition:
Technology-- lowering costs and creating new opportunities,
Convergence-- this business is in global consolidation.
Globalization--worldwide deregulation and capital flows.
A major trend we should focus here is consolidation , banks merge or acquire each other, to
provide one-stop service with a greater capital base.
Chart 1: Major Trend--Consolidation
From the chart above, it is easy to see the trend of consolidation between players. Morgan
Stanley merged with Dean Witter, Citibank acquired Solomon brothers, ETC. A detailed case
may be the Travellers-Smith Barney-Salomon combination. Travellers group provides
insurance products; Smith Barney provides an Investment banking operation with historical
strengths in equity; and Salomon provides historical strengths in debt. These types of
combinations could provide great synergy if managed well.
In addition, many investment banks have made asset management acquisitions in recent years:
Merrill Lynch bought Britain's Mercury Asset Management, Credit Suisse First Boston
bought Warburg Pincus Asset Management, and J.P. Morgan bought a significant stake in
American Century Investments. Investment management fee income is much more stable in
nature than trading and underwriting business.
Continued growth in this industry will be at a slower pace than in the 1990s. Like other
mature industries, this business suffers from over-capacity and a deteriorating pricing
structure. Players must know well about key value drivers to survive the competition. We will
illustrate industry value drivers in next part. From Chart 2 we could see, from a long-term
view, this industry still provides secular growth chances, especially in Fixed income and Risk
Chart 2: Segments Trends Analysis
2.2 Competition drivers in Investment Banking Industry
Almost most of the players had a very difficult time in the past two years due to a declining
market. But as we could see in Chart 3, some industry leaders’ five year ROE is still between
18% and 24%, much better than most manufacturing firms.
Chart 3: ROE of Industry Leaders
a. Human Capital
I-banks always try to get and empower the best people. Major players also work hard to be
smarter and faster by regularly adjusting the decision-making process.
Customers are increasingly informative with internet and they are becoming reluctant to
recruit several I-banks in a single project. With diminishing pricing power and customers’
new requirement, investment banks merge with each other, turning into a huge capital-
intensive business with broad-line service. Capital is particularly important for bulge-bracket
investment banks which provide a broad series of products. Besides, I-banks tend to deposit a
large bonds stock and make a bet on interest rate change. That also needs a great amount of
c. Risk Management.
Trading is always a highly risky business in I-banking. Even with well-calculated risk control
models, many I-banks are exposed to uncertain risks while could force them out of the
business. With greater amounts of capital at risk, risk management and review ability on a
daily and firm-wide basis becomes essential to any I-bank.
Investment banks can no longer earn easy money from IPO or M&A business. As a result,
they are trying new risky businesses to keep profitability. That’s the reason that even in bad
times, talents in risk control area will in great demand.
d. Customer Relationships
I-banking is a people business which used to stress customer network and mutual trust.
Nowadays all major investment banks are further segmenting their client base to use the most
professional force in customer service. Customers today have greater bargaining power.
Successful investment banks use advanced technology to re-engineer processes and to lower
costs. We list technology’s influence as follows.
Broadband and wireless devices allow customers to work continuously.
Customers can get best services from different investment banks.
Customers require one-stop service to save time and accelerate I-banks consolidation.
Research is going free.
Investment banks are outsourcing more non-key business.
f. Operating Discipline.
I-banking is such a mature business environment that all players must focus relentlessly on
costs and on allocating resources to the most promising opportunities. Organizational
discipline and teamwork efficiency are vital to I-banks.
How could I-banks survive in bad times? The ability to remain profitable in hard times and
the ability to allocate resources to the best growth opportunities, all depending on strict
g. Reputation and Integrity
Reputation and integrity are the foundation for all major investment banks. Most players’
reputation got seriously hurt in recently reported business fraud. In the future I-banks should
not earn money by clients’ ignorance regarding complicated products. In addition, I-banks
should make analysts’ reports more independent and objective.
Major Cost Driver--Salary (Source: Freeman Report 2002)
Chart 4: Major Cost Driver--Salary
Investment banking is a people business. Employee compensation often accounts for more
than 50% of the total operating expenses and thus is a major variable cost. From chart 4 we
could see managing directors could earn over 3 million USD in 1999 (good year) and still 1.2
million USD in 2002 (bad year). Thus banks tend to reduce people in bad years and get them
back in good times. Lots of corporate finance bankers were laid off while risky business
traders are in need.
A detailed example: Goldman Sachs Compensation
GS employee compensation costs is roughly 50% of the operating revenue and somewhat
stable even in bad times. Senior partners and limited partners stand on the top of power
pyramid in GS. Their compensation could range from one million to thirty million USD
annually. Next level managers like Managing Directors, Principles and Vice-President are
usually promoted from the best Associates. They could earn at least 500 thousand USD per
year. Associates are usually MBA graduates from top USA business schools or other
advanced degree holders. Their annual compensation is around USD 100 thousand in bad
times and over 200 thousand USD in good times. Lowest tier analysts are often best
undergraduate students from leading USA universities. Analysts could also earn USD 60
thousand per year.
Promotion to upper levels may cost 4 to 5 years at least. That is why many people left GS.
They could no longer feel comfortable with working 14 to18 hours everyday. As a rule, only
Partners, Managing directors and Principles can talk businesses with clients. That means the
routine daily work for low tier employees are strenuous and boring.
In GS, all Employees receive 360- degree appraisals from his direct boss and colleagues.
Stock options rewards are available and prevalent. Partners and Managing directors must be
responsible for their own business units profit targets. Professional pressure is enormous for
everyone and lots of medium level bankers simple got laid off in bad times. Stamina and
perseverance are critical to survive investment banking.
In brief, GS recruits the most clever graduates and stress teamwork. As to revenue creation
ability, GS employee ranks top among major rivals.
GS often ranks NO.1 in global M&A and stock IPO. Employees can benefit from trainings in
various areas. GS is also strengthening itself in derivatives trading and asset management
business. GS people are incredibly clever and most managers are glad to help low tier
employees. That may explain why GS ranks top in such a competitive industry.
We conclude that I-banking is a mature industry with fierce competition and slow growth.
Five to ten biggest players currently dominate the business and lots of smaller players will
disappear. The industry requires huge capital, high fixed cost (rental and technology) as well
as talented employee. Entry and exit barriers are both high and the returns are highly cyclical
in this industry. The industry may be attractive to some low profitable commercial banks,
insurance groups and some highly competitive niche players. We forecast the industry will
consolidate on a larger scale and smaller players will be ideal targets for acquisition. Only
industry leaders such as Goldman Sachs or Merrill Lynch are ‘safe’. With the strengthening
customer power, I-banking commission fee will reduce to a greater extent and more
customized products will be invented. Bulge bracket firms will extend their business to
middle-scale clients. Profits still exist in unexploited areas such as private wealth management
and risk management services. Most investment banking firms are likely to continue cutting
headcount, in some areas (mainly investment banking and institutional equity departments) as
much as 15% to 20%, before they are “right-sized” to meet the changed market environment.
3. Goldman Sachs Group Overview
In above, we have presented a detailed analysis on investment banking industry. In the
following, we will start to analyse Goldman Sachs Group.
3.1 Goldman Sachs Group Information
‘The Goldman Sachs Group, Inc. (GS) is a global investment banking, securities and
investment management firm that provides a range of services to a substantial and diversified
client base that includes corporations, financial institutions, governments and high-net-worth
individuals. The Company's activities are divided into three segments: Investment Banking,
Trading and Principal Investments and Asset Management and Securities Services. The
Investment Banking segment includes Goldman Sachs' financial advisory and underwriting
services. The Trading and Principal Investments segment is comprised of fixed income,
currency and commodities (FICC), as well as equities and principal investments, which
primarily represent net revenues from the Company's merchant banking investments. The
components of the Asset Management and Securities Services segment are asset management,
securities services and commission.
Two main rivals:
Morgan Stanley is a global financial services firm that operates in four business segments:
Institutional Securities, Individual Investor Group, Investment Management and Credit
Services. The Company's Institutional Securities business includes investment banking; sales,
trading, financing and market-making activities; and other activities, such as principal
investing and aircraft financing. The Company's Individual Investor Group business provides
comprehensive financial planning and investment advisory services designed to accommodate
individual investment goals and risk profiles. The Company's Investment Management
business provides global asset management products and services for individual and
institutional investors. The Company's Credit Services business offers Discover-branded cards
and other consumer finance products and services, and includes the operation of Discover
Business Services, a network of merchant and cash access locations primarily in the United
Merrill Lynch & Co., Inc. is a holding company that, through its subsidiaries and affiliates,
provides broker-dealer, financing, advisory, wealth management, asset management,
insurance, lending and related products and services. The Global Markets and Investment
Banking (GMI) segment provides equity and debt trading, capital markets services,
investment banking and strategic merger and acquisition advisory services to its clients
worldwide. The Company's Global Private Client (GPC) segment provides wealth
management products and services to assist clients in building financial assets and
maximizing returns relative to risk tolerance and investment objectives. The principal
subsidiaries engaged in asset management activities conducted through the Merrill Lynch
Investment Managers (MLIM) brand name are Merrill Lynch Investment Managers, L.P.
(MLIM LP) and Merrill Lynch Investment Managers Limited (MLIM Limited).’
3.2. Strategic analysis on GS
Strategy can be defined as a comprehensive plan that sets fit direction and allocate the
resources to achieve organizational objectives. Goldman Sachs has three levels of strategy:
corporate strategy , business strategy and functional strategy. We have found that Goldman
Sachs uses a combination strategy with focus on internal growth and some acquisition.
According to GS Annual Report, We summarize GS strategy as follows.
‘1. Priority on High Value Added Business
GS seek to build leadership positions in high value-added services for clients. For example, in
trading, GS structure and execute large and complex transactions for institutional investors,
pension funds and corporate clients around the world. In asset management, GS emphasizes
equity and alternative investment products and use established international presence to build
a global asset management franchise.
2. Seeking Stable Earnings
GS seeks to balance the stability of our earnings with return on equity and long-term earnings
growth. Trading businesses are key ingredients to GS’s success.
3. International Expansion
Global reach will allow GS to take advantage of growth in international markets. In Asia,
increased mergers and acquisitions advisory opportunities as a result of corporate
restructurings are attractive to all investment banks. In the longer run, additional opportunities
in asset management activities due to an expected shift towards privatization of pension
systems and changing demographics will appear.
4. Leveraging the Franchise
GS culture of teamwork fosters cooperation, which allows GS to provide clients with a full
range of products and services on a coordinated basis. GS investment bankers, for example,
refer clients who are selling their businesses to those in the Firm who manage wealth. In
addition, GS merchant banking investments in companies lead to future clients for investment
GS segments structure
Structure defines the existing method of departmentalization.
GS divides businesses into three business groups: Investment Banking, Trading and Principal
Investments, Asset Management and Securities Services. Services are offered throughout
three regions: America, Europe and Asia.
Goldman Sachs group is a holding company. Goldman, Sachs & Co. and Spear, Leeds &
Kellogg, L.P. are registered U.S. broker-dealers and futures commissions merchants.
Goldman Sachs (Japan) Ltd. is a Tokyo-based broker-dealer. Goldman Sachs International
is a UK registered broker.
GS CEO plus a management committee represent the highest power centre. Besides, GS have
two COO: one is responsible for Europe business and another for Asia, assisted by regional
management teams. GS stress teamwork and hierarchy to minimize the risks. Its organization
structure may be defined as a matrix with customer service focus and improved decision-
GS working style and staff
A suitable leadership style would empower individuals to assume responsibility and perform
to targets. GS CEO is a traditional hard-working corporate banker. GS always requires good
team players to sacrifice their individuality for the good of company. GS does not encourage
original thinking and creativity. Responsibility and financial rewards always come to team
players. GS people usually do ordinary projects very good, perhaps the best in I-banking. In
addition, though with strict hierarchy, all senior partners are accessible to low-tier employees
And most managers are frank. It’s rare among Wall Street firms. GS people are usually very
loyal and would not leak out its secrets even after leaving GS.
GS always hires fewer people than Morgan Stanley and Merrill Lynch. However, GS has the
best revenue/ per employee ratio compared with the two rivals.
GS core competences
a. Focus on most profitable segments in I-banking
GS allocates main resources on most profitable segments such as global IPO and M&A,
High-yield securities . Other players such as Citibank are struggling in all businesses with
b. Superb Clients Network
GS focuses on building long-term client relationships and most revenues are from existing
clients. ‘In trading businesses, GS structure and execute transactions across a wide array of
markets and countries to meet clients' needs. In asset management business, GS managed
assets for three of the five largest pension pools in the United States.’
c. Outstanding People and Culture
GS was ranked number seven in Fortune magazine's "The 100 Best Companies to Work for
in America" in January 1999 and was ranked number three in Fortune magazine's 1999 "The
Top 50 MBA Dream Companies", the highest-ranked investment banking and securities firm
in each case. I-banking is a traditional business with strict requirements on details execution,
GS people always excel and perform really well in business.
'They're predictable, they're not adaptable and they're very, very good,' one banker from
archrival Morgan Stanley Dean Witter says of Goldman people, in Lisa Endlich's book
Goldman Sachs: The Culture of Success.
'The thing that drives the firm on is that is has always seen itself as an outsider,' comments
another banking sector source. 'Goldman has always been viewed by the rest of the industry
as a bit strange. That's part of its strength - people are afraid of Goldman and don't understand
why it's so successful.'
d. Global network
GS has become one of the few truly global investment banks with the ability to execute large
and complex cross-border transactions. GS is deemed No.1 on global M&A and often ranks
top on the league table of global stocks IPO. GS senior executives have good relationship
with governments worldwide: Rubin, a previous GS senior partner, ever worked as US
Treasury Secretary; Many GS managing directors were previous senior government officials
in different countries.
Could GS do better?
In general, GS should reduce costs to a greater extent concerning employees’ compensation
and corporate financing costs. Meanwhile, to keep a sustainable growth rate, GS should
pursue an acquisition focused strategy to expand clients’ network and business expertises at
least as fast as rivals.
a. GS should reduce senior executives’ compensation and options in bad times.
GS net earnings did not fall proportionally to revenues and employee compensation account
for 50% of operating revenue. That hints GS compensation system was somewhat rigid even
in bad times. Even downsizing junior employees on large scale did not help much. As a result,
GS has to reduce senior executive’s compensation and options in bad times. In addition, GS
should study the case of its rival--Bear Stearns, which always focus on continuous cost
reduction and recruiting best talents available in bad times.
b. GS should acquire more asset management firms and derivatives trading firms
to increase core competence in the future.
c. GS should form tight strategic partnership with commercial banks and insurance
firms--to gain access to cheap capital in bad times.
4. Financial Analysis on Goldman Sachs
GS serves Fortune 500 firms worldwide. Its business revenues are subject to macro-
economic changes, clients’ industry cycle changes as well as geographic market changes.
GS Fees and Commissions continue to shrink. Costs reductions contributed strongly to results
in 1Q02 and 4Q02 but have lost momentum in 1Q03. It is time for GS to consider whether it
will need to reduce headcount and other expenses in keeping with lower revenue streams.
Investment performance from Trading has stabilized in absolute Capital continues to pour into
the Trading operation. This is a function of lower capital intensity in the company’s fee-
generating businesses, and a relatively low dividend payout ratio (12% in 2002).
Chart 5. GS Common-Size Income Statement
(Total Revenues as a basis of comparison)
2002/11/29 2001/11/29 2000/11/29
Investment banking 11.25% 11.81% 16.18%
Trading and principal investments 17.78% 20.08% 19.78%
Asset management and securities 21.66% 14.73% 11.32%
Interest income 49.31% 53.38% 52.72%
Total revenues 100.00% 100.00% 100.00%
Interest expense 38.80% 49.22% 49.73%
Revenues, net of interest expense 61.20% 50.78% 50.27%
Compensation and benefits 29.51% 24.73% 23.55%
Nonrecurring acquisition awards 0.00% 0.00% 0.88%
Amortization of employee initial public 1.28% 1.49% 1.30%
offering and acquisition awards
Brokerage, clearing and exchange fees 3.73% 2.71% 1.74%
Market development 1.34% 1.30% 1.53%
Communications and technology 2.31% 1.94% 1.32%
Depreciation and amortization 2.70% 1.97% 1.34%
Amortization of goodwill and 0.56% 0.83% 0.14%
identifiable intangible assets
Occupancy 2.79% 1.90% 1.33%
Professional services and other 2.75% 2.04% 1.94%
Total non-compensation expenses 16.17% 12.69% 9.33%
Total operating expenses 46.96% 38.91% 35.06%
Pre-tax earnings 14.23% 11.87% 15.21%
Provision for taxes 4.98% 4.45% 5.92%
Net earnings 9.25% 7.42% 9.29%
Income Statement Trend Analysis 2000-2002
(Year ended 2000 as a basis of comparison)
Revenues 2002/11/29 2001/11/29 2000/11/29
Investment banking 48.17% 68.87% 100.00%
Trading and principal investments 62.24% 95.80% 100.00%
Asset management and securities 132.46% 122.75% 100.00%
Interest income 64.78% 95.54% 100.00%
Total revenues 69.25% 94.36% 100.00%
Interest expense 54.04% 93.40% 100.00%
Revenues, net of interest expense 84.30% 95.30% 100.00%
Compensation and benefits 86.76% 99.06% 100.00%
Nonrecurring acquisition awards 0.00% 0.00% 100.00%
Amortization of employee initial public 68.46% 108.41% 100.00%
offering and acquisition awards
Brokerage, clearing and exchange fees 148.69% 147.12% 100.00%
Market development 60.47% 80.24% 100.00%
Communications and technology 121.38% 138.85% 100.00%
Depreciation and amortization 139.91% 139.00% 100.00%
Amortization of goodwill and 282.22% 577.78% 100.00%
identifiable intangible assets
Occupancy 144.77% 134.32% 100.00%
Professional services and other 98.44% 99.22% 100.00%
Total non-compensation expenses 120.04% 128.32% 100.00%
Total operating expenses 92.77% 104.71% 100.00%
Pre-tax earnings 64.80% 73.63% 100.00%
Provision for taxes 58.32% 70.97% 100.00%
Net earnings 68.93% 75.32% 100.00%
Based on chart 5 and figures from Yahoo, we will review Goldman Sachs’ financial
conditions as follows. (Many investment banks use Return on equity and Pre-tax margin as
major benchmarks to measure their different business segments. ROE= Profit Margin*Asset
Turnover*Leverage level. Investment banks usually have very low asset turnover ratio and a
high leverage level since debts serve as capitals for them. )
We will use average return on equity (ROE) and Pre-tax margin ratio (from 1997 to 2002) to
compare GS with its two main rivals—Merrill Lynch and Morgan Stanley.
Average ROE for GS is 20.6% (1999-2002 only), less than the figure of Morgan Stanley
(23.6%) but better than Merrill Lynch (18.5%).
However, in 2002, GS ROE is only 11.3%, less than both Morgan Stanley (14.8%) and
Merrill Lynch (12%).
As to pre-tax margin in 2002, GS figure is 23%, better than Merrill Lynch (21%) but less
Than Morgan Stanley (25%).
Besides, compared with 2001’s figure, the top three investment banks’ revenue in 2002 all
decreased with a similar scale between 12% and 15%.
As to the ratio of 2002 revenue per employee, GS’s figure is 1.2 million USD per employee,
the best of the three.
After a comparison with rivals, we will make a brief internal analysis on GS.
GS business segments analysis
Pre-tax earning changes in business segments (Compared with the previous year)
I-Banking -47.7% -58.34%
Trading and Principle -19.67% -49.96%
Asset Management -0.56% +34.15%
Total -12% -26.37%
Problems in GS
a. Except asset management and fixed income business, all other businesses kept declining.
b. Reduction of operating expenses (mainly employee compensation) did not fall
proportionally with the reduction of pre-tax earnings.
c. If employee stock options are all realized in 2002, the diluted earnings/share will be only
USD 4.03/ per share as announced on the annual report 2002.
d. If measured by capital profitability, the capital employed in US and Europe performed less
well than the figure of Asia in 2002. Besides, only GS Asia earning figure keeps rising among
all business regions.
GS Cash Flows (Billion)
2002 2001 2000
Cash-flow 4.82 6.91 3.87
CF from operation 10.08 2.87 1.61
CF from investment 1.10 1.91 3.66
CF from financing 9.09 2.08 2.86
CF change -30.25% +81%
In 2002, cash flows from operation increased 250% compared with 2001’s figure
due to the issue of long-term debt, as well as accounting adjustment of including the net
repurchase securities (originally this item is included in cash-flow from financing).
Cash flows from financing increased 337% compared with 2001.
Total cash flow in 2001 increased 81% compared with 2000 while CF decreased 30.25% in
Problem: In 2002, GS might had some problems to achieve enough operating cash-flow
itself. As a result, GS increased borrowing and debts-issue.
GS Capital (Billion)
GS defines its capital as shareholder equity plus long-term borrowings.
Total capital in GS 2002 fiscal year is 57.71 billion and in 2001 the figure is 49.25 billion,
increase in capital is due to the increase of long-term borrowings (unsecured).
In 2002, GS owns highly liquid assets around 30.06 billion, adding its shareholder equity of
19 billion, GS has enough ability to cover short- term liability and market crisis. GS long-term
borrowing grade is A+ (Standard and Poor) while its short-term grade is A-1.
GS VaR ratio
VaR is the potential loss in value of GS trading positions, using a one-day horizon and 95%
confidence level. This means a one in twenty chance that GS daily trading loss will be greater
than then VaR ratio.
GS average daily VaR increased to 46 million in 2002 from 39 million in 2001, due to
increase in interest rate risk. It may hint GS is increasing risk-orientation.
We conclude GS has acceptable liquidity and capital ratio though it is highly leveraged. Debts
level and risk control system are acceptable. However, GS was trying to increase capital base
through debts issue and expanded borrowings. GS might need to create more operating cash-
flow internally in the future. In addition, GS risk control system might change financial
markets’ mechanics and need be reviewed often.
Previous insider trading litigation and analyst fraud hurt GS reputation seriously.
GS should try hard to resume investors’ confidence.
GS profitability from business segments and geographic areas vary a lot. More segmentation
should be exploited in the future and resource should be allocated to most profitable areas.
Lastly, operating expenses (mainly employee compensation) should be reduced further. Asset
management, risk management and investment banking business in emerging economies
should be key target areas for GS in the near future.
5. Risks Analysis on Goldman Sachs
Based on GS annual reports, we list main business risks to GS in two categories as follows.
a. Risks from global financial markets and regulation, litigation.
In 2001 and 2002, global IPO and M&A declined sharply. Declines in the volume and number
of investment banking transactions may continue to increase industry wide price competition.
In addition, GS was involved into a litigation of insider trading, which hurt its reputation
badly. Substantial legal liability or a significant regulatory action against Goldman Sachs
could hurt GS seriously. Investors are no longer satisfied with GS star analysts such as Mary
Meeker—the queen of internet. GS must face the challenges from both market downfall and
investors’ mistrust. In addition, lots of GS principal subsidiaries are subject to extensive
regulation in the United States and elsewhere. GS group is a holding group, ‘compliance with
the rules of these regulators may prevent GS from receiving distributions, advances or
repayment of liabilities from these subsidiaries. Due to competitive factors, GS may be force
to extend credit and price more aggressively to customers. Customers’ default risk may arise
from events that are difficult to detect or foresee.
GS Market Risks
Interest rate risks primarily result from exposures to changes in the level, slope and curvature
of the yield curve, the volatility of interest rates, mortgage prepayment speeds and credit
Equity price risks result from exposures to changes in prices and volatilities of individual
equities, equity baskets and equity indices.
Currency rate risks result from exposures to changes in spot prices, forward prices and
volatilities of currency rates.
Commodity price risks result from exposures to changes in spot prices, forward prices and
volatilities of commodities, such as electricity, natural gas, crude oil, petroleum products, and
precious and base metals.
b. Volatility in large trading, liquidity and capital
Market fluctuations and trading volatility may adversely affect GS, including interest rate and
credit products, currency, commodity and equity positions and merchant banking investments.
Further weakness in global equities markets could adversely impact GS’s trading businesses
and impair the value of its goodwill and identifiable intangible assets. If traders made errors in
routine trading or hedging, GS may incur huge losses. GS hedging strategies and other risk
management techniques may not be effective in mitigating its risk.
Liquidity (ready access to funds) is essential to investment banks.
A sudden market downfall may make GS bankrupted at once. Counter-party default may
bring great liquidity risk, too. Credit ratings are important to GS liquidity. A reduction in GS
credit ratings could adversely affect GS liquidity and competitive position, increasing its
borrowing costs largely. In the past, a downgrade to Lehman Brothers’s credit grade reduced
its annual profit around $25 million.
Goldman Sachs’ total capital increased 17% to $57.71 billion as of November 2002,
compared with $49.25 billion as of November 2001. The increase in total capital resulted
primarily from an increase in long-term borrowings to $38.71 billion as of November 2002
from $31.02 billion as of November 2001. The weighted average maturity of GS long-term
borrowings as of November 2002 was approximately 5 years. GS swapped a substantial
portion of the long-term borrowings into U.S. dollar obligations with short-term floating
interest rates in order to minimize the exposure to interest rates and foreign exchange
Shareholders’ equity increased by 4% to $19.00 billion as of November 2002 from $18.23
billion as of November 2001.
c. Risk Control procedure in GS
We think more probably risks for GS would be trading risks or litigation risks. Currently, GS
managed its risks as follows:
Trading desk managers have the first line of responsibility for managing
risk within prescribed limits. These managers have in-depth knowledge of the primary sources
of risk in their individual markets and the instruments available to hedge the exposures.
In addition, a number of committees are responsible for establishing trading limits, for
monitoring adherence to these limits and for general oversight of GS risk management
6. GS Valuation Ratios
In this part, we will compare GS Valuation ratios with its two rivals: Morgan Stanley (MWD)
and Merrill Lynch (MER). (Data: July 11, 2003.)
a. GS Quantitative Summary
Chart 6: GS Five-Year Stock Chart
Quantitative ratios formulas
gs beta= covar (sp500 returns, gs returns) / varp (sp500 returns).
gs annual variance=12*varp (gs monthly returns)
gs standard deviation=sqrt (gs annual variance)
gs five-year annual return=12*average(gs monthly returns)
gs sharp ratio=(gs five-year annual return-one year us bond rate)/ gs annual
Goldman Sachs Quantitative Ratios Summary
(May 4, 1999- July 11, 2003)
Annual Standard Deviation 41.35%
Annual Variance 17.10%
Five-Year Annual Return 6.15%
1-Year US Treasury Rate 1.28%
Sharp Ratio 11.80%
Analysts Estimate Five-Year Revenue Growth 14%
GS, MDW and MER stocks all perform relatively a bit better than S&P 500. But according to
Standard & Poor’s opinion, all the three investment banks did not perform better than the
whole financial industry index.
GS stock price was on an upward curve between Mid-1999 and Mid-2000 but kept
downwards since then. In the first half of 2003, GS stock bounced a lot with the news of
Investment banks usually have a higher Beta than 1.0 and thus more volatile than S&P 500.
MWD has the highest Beta among the three players.
b. GS Valuation Ratios on July 11, 2003 (Chart 7)
Valuation ratios such as P/E, Return on equity, Price/Book, Earning / Per Employee are most
suitable ratios to value investment banks. Based on Quicken financial software, we list
valuation ratios for the three biggest investment banks as follows.
Price and valuation ratios
Price 52-Weeks Range 60-Months Beta 50-day AVG 200-Day AVG
GS 87.32 58.57-91.98 1.75 82.48 73.86
MWD 46.66 28.80-50.49 2.06 45.51 41.11
MER 49.55 28.21-51.69 1.53 45.10 39.42
EPS Price/Earnings Price/Sales Price/Book
GS $4.03 18.80 1.63 2.04
MWD $2.69 18.10 1.51 2.26
MER $2.63 18.60 1.16 1.97
Annual Revenue(mil) 1-yr growth 3-yr growth 5 yr-growth 10-yr growth
GS $22,854.0 (11/2002) -9.5% -9.7% N/A* N/A*
MWD $32,415.0(11/2002) -16.2% -10.2% 1.5% N/A*
MER $28,253.0(12/2002) -19.7% -10.6% -2.3% 9.5%
Annual EPS 1-yr growth 3-yr growth 5 yr-growth 10-yr growth
GS $4.03(11/2002) 20.8% -10.4% N/A* N/A*
MWD $2.69(11/2002) -11.9% -18.1% -1.2% N/A*
MER $2.63(12/2002) N/A* -17.5% -4.3% 4.9%
Divident/Share Yield 3-yr dividend growth 5-yr dividend growth 10 dividend yr-growth
GS $0.48 0.5% 0.0% N/A* N/A*
MWD $0.92 2.0% 3.6% 16.8% N/A*
MER $0.64 1.3% 3.8% 9.4% 16.0%
Data as of 07/11/2003
Latest Annual Revenue
1,3,5,10-yr Revenue Growth
Latest Annual EPS
Current Total Debt
Current Long-term Debt
Return on Assets
3,5,10-yr Average Return on Assets
Return on Equity
3,5,10-yr Average Return on Equity
Large cap: over $5 billion in market
Mid cap: between $1 billion and $5 billion
Small cap: $1 billion or less
GS P/E ratio (18.8) is similar to its two rivals while GS has the highest ratio on Price/Sales,
Book value/ Share, Revenue/ Per employee. That may hint GS has the best management
Using a three-year average revenue growth rate, all I-banks have a negative growth rate
around -10% but GS performed better in 2002. Using three- year return on equity ratio as
benchmark, Morgan Stanley is the best among the three, with a ROE of 20.3%. GS ROE is
14.1 and acceptable to investors. All three have low dividend payout ratio and investors can
only expect capital appreciation. All three have similar capitalization and highly leveraged.
Merrill Lynch long-term debt/ equity ratio is the highest of the three and more volatile.
If we define a P/E ratio as: current stock price / estimate earning at fiscal year end,
a suitable P/E ratio range for GS would be 16-18, under 16 P/E GS would be a good buy and
over 18 P/E investors should sell GS stock.
7.1 Review of Valuation Theory
In the following we will briefly present the two most popular valuation methods: Discounted
Cash Flow valuation (DCF) and Price Multiples valuation. Price Multiples method is useful to
measure relative values while DCF method is a better way to measure absolute values.
Discounted Cash Flow Valuation theory
A firm’s value can be calculated by discounted free cash flow to firm (FCFF) at the cost of
capital (WACC), or by discounted free cash flow to equity (FCFE) at the cost of equity(ROE).
Cash flows to Discount: Dividends or Free Cash Flows to Equity or Free Cash Flows to
Free Cash Flow to Firm = Operating Cash Flow- Increase in Capital Expenditures – In
crease in operating working capital.
Operating Cash Flow= Net Earning +Depreciation + (1-t)*interests paid on debt-(1-
t)*interest received on cash, short term securities and investments.
Operating working capital=Operating current assets - Operating current liabilities.
Cost of debt= Yield on the company’s debt or interest divided by average debt.
Cost of equity=Investor’s required return for holding equity in a firm,
Cost of equity= risk-free rate+ Equity Beta*Risk Premium.
Risk-free rate: Practitioners usually use 5-year or 10-year US bonds rate.
Cost of capital: WACC = (Cost of equity*Market value of equity/Market value of firm) +
(Cost of debt*(1-marginal tax rate)*Market value of debt/ Market value of firm).
Expected Growth: Stable Growth, Two Stages of Growth: High Growth -> Stable Growth.
Cost of Equity
The cost of equity is the rate of return that investors require to make an equity investment in a
firm. We can use CAPM to estimate the cost of equity;
Measures risk in terms on non-diversifiable variance
Relates expected returns to this risk measure.
It is based upon several assumptions:
(a) that investors have homogeneous expectations about asset returns and variances
(b) that they can borrow and lend at a risk-free rate
(c) that all assets are marketable and perfectly divisible
(d) that there are no transactions costs and that there are no restrictions on short sales.
Beta: The non-diversifiable risk for any asset can be measured by the covariance of its returns
with returns on a market index, which is defined to be the asset's beta.
cost of equity= risk-free rate+ Beta*Risk Premium.
The long-term USA government bond rate is the appropriate risk-free rate.
Practitioners usually use current 5-year or 10-year US Government bonds rate
General Valuation Formulas.
For Stable Firm:
For two stage growth:
Definitions of Terms
V0= Value of Equity (if cash flows to equity are discounted) or Firm (if cash flows to firm are
CFt = Cash Flow in period t; Dividends or FCFE if valuing equity or FCFF if valuing firm.
r = Cost of Equity (if discounting Dividends or FCFE) or Cost of Capital (if discounting
g = Expected growth rate in Cash Flow being discounted
gn= Expected growth in Cash Flow being discounted in stable period
n = Length of the high growth period in two-stage model
7.2. What is unique about investment bank valuation?
Debt: Raw Material or Source of Capital
When we talk about capital for non-financial service firms, we tend to talk about
both interesting bearing debt and equity. However, rather than view debt as a source of
capital, most I-banks seem to view it as a raw material. Consequently, capital at I-banks
seems to be more narrowly defined as including only equity capital.
Net capital expenditures and working capital
Unlike manufacturing firms that invest in plant, equipment and other fixed assets, I-banks
invest in intangible assets such as brand name and human capital. Consequently, their
investments for future growth often are categorized as operating expenses in accounting
statements. Not surprisingly, the statement of cash flows to a bank show little or no capital
expenditures and correspondingly low depreciation.
As to working capital, if we define working capital as the different between current assets and
current liabilities, a large proportion of a bank’s balance sheet would fall into one or the other
of these categories. Changes in this number can be both large and volatile and may have no
relationship to reinvestment for future growth.
To value a levered firm, we must firstly estimate the Free Cash Flow to Equity.
Free Cash Flow to Equity = Net Income – Net Capital Expenditures – Change in non-cash
working capital – (Debt repaid – New debt issued).
However, estimation of free cash flows for an investment bank is very difficult since we
cannot calculate exact capital expenditures figure, as well as change in net working capital.
On the other hand, investment banks tend to have similar capital structure and leverage ratios.
Suggestion: Debt, for an investment bank, is difficult to define and measure, making it
difficult to estimate firm value or costs of capital. Consequently, it is far easier to value the
equity directly in a financial service firm, by discounting cash flows to equity at the cost of
equity. Secondly, capital expenditures and working capital, which are required inputs to
estimating cash flows, are often not easily estimated at I-banks. In fact, much of the
reinvestment that occurs at these firms is categorized under operating expenses.
The difficulties associated with defining debt make equity multiples such as price earnings or
price to book value ratios better suited for comparing I-banks.
In the following, we will try to value Goldman Sachs with Gordon stable growth model. We
assume GS is a mature company in a highly competitive industry.
Value GS with GORDON Growth Model
GORDON stable growth model
Value of Stock = DPS1 / (r - g),
where DPS1 = Expected Dividends one year from now
r = Required rate of return for equity investors
g = Annual Growth rate in dividends forever
Works Best For:
firms with stable growth rates .
firms which pay out dividends that are high and approximate FCFE .
firms with stable leverage.
Why we could use Gordon Growth Model to value investment banks?
Investment banks’ size makes it unlikely that they will generate extraordinary growth
I-banks’ free cash flows to equity are difficult to compute.
I-banks have similar leverage.
Illustration: Goldman Sachs Group
A Rationale for using the Gordon Growth Model
Investment banks in an extremely competitive environment. From yahoo we know that
average estimate GS growth rate is around 14% in the next five years.
As an investment bank, free cash flows to equity are difficult to estimate. Hence, we have to
use dividends. GS has kept a steady annual dividends payout of USD 0.48/Share in the past
From Yahoo we know GS 2002 diluted EPS is $4.03 and estimate 2003 diluted EPS is $5.05.
Thus GS 2003 estimate dividends= (0.48/4.03)*5.05 = $0.60/Share.
The leverage of Goldman Sachs is high and unlikely to change over time.
GS 2003 Estimate Dividends per share = $ 0.60
Our Estimate Long-term Growth Rate = 13.5% (Adjusted by : 14%-0.5%)
Five-Year Monthly Stock Beta = 1.7329.
We will use a 10 year bond-rate here (from Bloomberg) since most I-banks have a business
cycle around 10 years.
Cost of Equity for GS= US 10-Year Bond Rate (4.25%) +GS Five-Year Beta (1.7329) * A
Historical US Stock Market Risk Premium (6%) =14.65%. (Source: Bloomberg and Yahoo).
Value of GS Equity on July 12, 2003 = 0.60 / (0.1465 -0.135) = $ 52
GS was trading for $ 87.32 on the day of this analysis. (July 11, 2003)
Implied Growth Rate for price $87.32 = 13.96% .
(Notes of concern: The beta is high for a stable growth firm. It reflects the additional risk that
many investment banks have encountered and exposed themselves to in the last few years. GS
200-day average price was 73.86.)
7.3. Price Multiples Valuation
In previous discussions, we have suggested price multiples valuation method is more fit to
value investment banks. In the following we will value Goldman Sachs with two different
price multiples. We will use the average Price/Earning and Price/Book ratio of its two rivals--
Merrill Lynch and Morgan Stanley.
Price Multiples Valuation Theory
Price multiples are easy to calculate and can compare the relative values of firms. However, it
is hard to use price multiples to determine the true value of a firm and it does not incorporate
growth Rates. P/E ratio tends to vary a lot with the changing market. Typical ratios include
P/E, EV/EBIT, EV/EBITDA, EV/ INVESTED CAPITAL, and Price/Book.
EV (Enterprise Value) = Market value of common equity + Market value of preferred stock
+Market value of employee stock options + Market value of debt .
Invested Capital=( Book value of interesting bearing debt+ Book value of preferred stock+
Book value of common stock)
Price/Book= Current stock price / (book value of common stockholders’ equity/common
shares outstanding at balance sheet date)
MVA (Market Value Added) = Enterprise Value-Invested capital
It is an intuitively appealing statistic that relates the price paid to current earnings.
It is simple to compute for most stocks, and is widely available, making comparisons across
It is a proxy for a number of other characteristics of the firm including risk and growth.
Price to Book Ratio
The price to book value ratio for an I-bank is the ratio of the price per share to the book value
of equity per share.
Price to Book Ratio = Price per share / Book value of equity per share.
The book value of equity is the difference between the book value of assets and the book
value of liabilities.
Advantages of using price/book ratio
It provides a relatively stable, intuitive measure of value which can be compared to the market
Given reasonably consistent accounting standards across firms, price-book value ratios can be
compared across similar firms for signs of under or over valuation.
Even firms with negative earnings, which cannot be valued using PE ratios, can be evaluated
using price-book value ratios.
Disadvantages of using price/book ratio
Book values, like earnings, are affected by accounting decisions on depreciation and other
variables. When accounting standards vary widely across firms, the price-book value ratios
may not be comparable across firms.
Book value may not carry much meaning for service firms which do not have significant fixed
The book value of equity can become negative if a firm has a sustained string of negative
earnings reports, leading to a negative price-book value ratio.
GS Valuation with P/E and P/Book ratios
In the following, we will value GS valuation ratios, using the average P/E and Price/Book
ratios of its two rivals, based on the data on July 11, 2003.
Price and valuation ratios
Price 52-Weeks Range 60-Months Beta 50-day AVG 200-Day AVG
GS 87.32 58.57-91.98 1.75 82.48 73.86
MWD 46.66 28.80-50.49 2.06 45.51 41.11
MER 49.55 28.21-51.69 1.53 45.10 39.42
Price P/E P/Sales P/Book
GS $4.03 18.80 1.63 2.04
MWD $2.69 18.10 1.51 2.26
MER $2.63 18.60 1.16 1.97
½*( MWD+MER ) 18.35 2.115
GS Valuation with Price/Earning: GS Value/Share=4.03*18.35=$73.95/Share
GS Valuation with Price/Book: GS Value/Share=42.80*2.115=$90.52/Share
7.4. Residual Income Valuation Method
Empirical analyses such as that conducted by Professor Penman (Columbia University, 2000)
have found that the residual income model outperforms the other two models in valuing share
prices for listed firms in the US.
According to residual income (or abnormal earning) theory, A firm’s equity value=Book
Value (time 0) + Present Value of all residual incomes (abnormal earnings) in the future.
Year 2003 2004 2005 2006 Terminal Value at 2005
Book Value at beginning of Year 44.63 50.92 58.10
Estimate Dividend -0.60 -0.85 -0.97 -1.10
Estimate EPS 5.05 7.14 8.15 9.30
Cost of Equity (14.65%) -5.89 -6.54 -7.46 -8.51
Residual Value(RE) -0.84 0.60 0.69 0.78 68.21
RE Discount at ROE (14.65%) -0.84 0.53 0.52 0.52 51.89
GS price 91.76
Cost of Equity 14.65%
Long term Growth after 2003 13.50%
Long-term ROE after 2003 16%
Book Value (t+1)= Book Value ( t )+ EPS(t)-DPS(t)
GS price=Book at beginning of 2003+PV of RE(2003-2004)+PV of Residual Value 2005
EPS after 2003=Book(t)*16%
Dividend payout ratio=0.1188(constant)
Discount Factor=Cost of equity=14.65%
Terminal Value after 2005= (0.78/ (0.1465-0.1350))/ (1+0.1465) ^2
In our paper we firstly present the competitive landscape in investment banking. Secondly,
we present valuation theory and value GS stock with three methods.
We conclude that I-banking is a mature industry with fierce competition and slow growth.
Employee compensation is the major cost driver in this business. This industry is in global
consolidation and many Niche players will disappear. Profit margins from traditional
investment banking and M&A business are shrinking. In the future, I-banks should allocate
resources to Fixed Income or Asset Management or Emerging Economy businesses.
As to valuation part, we explored into GS financial statements and made a comparison with
its two rivals. Then we present the relevant valuation theory framework. According to our
calculation with three different methods, GS stock price should range from $52 to $91.76.
Attachment 1: 2002 Investment Banking League Table (Note 6)
Top Five Player’s market share
Attachment 2: Investment Banking Business in 2002
a. 2002 Review on I-banking (Note 7)
‘Economy recovery in 2002 was modest. Continued weakness in capital spending, combined
with an erosion of corporate and investor confidence and increased geopolitical risks, was
accompanied by significant declines in global equity prices and corporate activity.
U.S. Congress passed the Sarbanes-Oxley Act of 2002 to deal with corporate scandals and
several large corporate bankruptcies. The provisions of Sarbanes necessitate significant
changes to corporate governance and public disclosure. In addition, investment banks have
been and continue to be the subject of increased regulatory scrutiny regarding research and
initial public offering practices.
This difficult economic and regulatory environment continued to provide a challenging
business climate for investment banks. In 2002, industry-wide completed mergers and
acquisitions declined 49%, industry-wide initial public offerings declined 17% and industry-
wide equity underwriting volume declined 7%. The fixed income markets, which generally
performed well for a second straight year, were characterized by a steep yield curve, low
interest rates and significant volatility in credit spreads.
Real GDP growth in 2002 rose to approximately 2.4%, an increase from 0.3% in 2001
. Corporations remained cautious and investment continued to decline, while consumer and
housing spending held up relatively well. After cutting overnight interest rates aggressively
during 2001 (25 basis points of which fell in the first month of our 2002 fiscal year), the U.S.
Federal Reserve left rates unchanged until November 2002, when renewed signs of economic
weakness prompted a 50 basis point cut in the overnight lending rate.
The European economy remained weak in 2002, with the German economy showing
particular weakness. Real GDP growth in Europe for the 2002 calendar year was
approximately 1.1%, lower than the 1.6% recorded in 2001. European equity markets
recorded particularly sharp declines through the year. The European Central Bank and Bank
of England left interest rates unchanged throughout 2002, but in response to continued
economic weakness, the European Central Bank lowered interest rates by 50 basis
In Japan, export demand and industrial production rebounded quite strongly in the middle of
2002, driving overall growth rates positive, as global demand improved and an improvement
in other Asian economies lifted Japanese exports. Equities markets in Japan rose early in
2002 but fell sharply as the outlook for a sustained recovery receded.
Growth in other Asian economies picked up sharply in late 2001, reflecting an improvement
in technology demand in the United States and, in some countries, an increase in domestic
spending. Export growth decelerated later in 2002, leading to renewed pressure on some
economies, but the region generally remained stronger than other areas. China, in particular,
has continued to record strong growth and its strength has benefited other regional trading
partners. Despite large falls in global equities markets, most Asian equity markets (outside of
Japan) performed better than those in other regions.’
b. The SARBANES – OXLEY ACT of 2002
The SARBANES – OXLEY ACT is the most influential act on I-banking business. Any
finance professional related to corporate fraud will be punished to a new level. Stock analysts
will need to behave more objective and independent.
In the following we will examine the act briefly.
Redefining Corporate Integrity, Governance and Disclosure
A company must disclose in periodic reports whether the audit committee contains at least
one person who is a financial expert, such as a former auditor, controller or CFO.
New Crimes and Increased Criminal Penalties
Knowingly tampering with or falsifying documents with the intent to obstruct or influence an
investigation can result in fines, imprisonment for up to 20 years or both.
Accountants who knowingly and wilfully fail to maintain work papers for five years may be
fined imprisoned for up to 10 years or both.
Certifying a report knowing that it does not comply with law can result in fines up to
$1,000,000, imprisonment for up to 10 years or both. Doing so wilfully can result in a fine of
up to $5,000,000, imprisonment for up to 20 years or both.
Knowingly taking action against someone for providing truthful information relating to a
covered offence can result in fines, imprisonment for up to 10 years or both.
Conspiring or attempting to violate any of the new laws, whether successful or not, results in
the same penalties as those prescribed for the offence.
The maximum sentence for securities fraud has been increased to 25 years, the maximum
sentences for mail fraud and wire fraud have been increased to 20 years and the maximum
sentence for defrauding a pension fund has been increased to 10 years.
New Civil Cause of Action and Increased Enforcement Powers
A whistleblower who prevails in an action alleging retaliation by an employer for his
cooperation in either a potential securities fraud investigation or a securities fraud action
brought by the SEC may be reinstated and recover back pay with interest and special
The SEC may obtain a temporary restraining order that prohibits a company from making
extraordinary payments to insiders during the pendency of an investigation.
The SEC may bar individuals from serving as officers or directors of a public company as a
result of violations of the securities law that render them unfit for those positions.
The Act adds to the SEC’s enforcement powers by lengthening the statute of limitations for
private securities fraud claims to the earlier of two years after the discovery of the facts
constituting the violation or five years after the occurrence of the violation, and by limiting
the use of bankruptcy to avoid liability for securities fraud.
All audit and non-audit services (with some exceptions) must be pre-approved by the audit
committee of the company, and such approval must be disclosed to investors.
Audit partners must be rotated every five fiscal years.
Auditing firms must report to audit committees recommended alternative accounting
treatments that have been discussed with management.
Auditing firms cannot provide audit services to a company if a former employee of the
auditing firm who participated in an audit of the company within the past year now serves as
CEO or CFO for the company or holds a similar position.
The Public Company Accounting Oversight Board
The Act establishes a Public Company Accounting Oversight Board under the aegis of the
Commission. The Board will register public accounting firms, establish audit preparation
standards, regularly inspect registered accounting firms and investigate and discipline
individuals or entities who violate its rules. The Board will be composed of five members
appointed by the Commission, two of whom must be, or must have been, CPAs. The other
three members must not have worked as accountants.
The Act includes measures:
preventing conflicts of interest between securities analysts and investment banking activities
regarding approval of research reports;
prohibiting broker-dealers from retaliating against analysts for negative research reports; and
requiring disclosures of investments by a broker-dealer or securities analyst in a company that
is the subject of a report regardless of whether the company has compensated the broker-
dealer or analyst, the company is a client of the broker-dealer, or the analyst received
compensation based upon investment banking revenues.
Attachment 3: GS Management Team Profile (Note 8)
a. GS Management Overview
Before its 1999 IPO, Goldman Sachs was usually co-managed by two senior partners.
One of the two would usually come from traditional investment banking business and another
from more volatile trading business. For example, Wenberg and Whitehead co-led GS before
1980s, Friedman and Rubin in 1980s, Corzine and Paulson in the 1990s. However, Corzine
and Paulson never worked together before their cooperation of the firm and Corzine was
forced out before 1999 IPO. From then on, Paulson became the only senior partner and the
management style became ‘a CEO plus two COO ’. Paulson, current CEO, is a traditional
banker and the next CEO, probably Thain or Blankfein all has trading background.
Paulson was promoted from Goldman's investment banking business, developing a reputation
for being a good client relationship man. He is also regarded as a hard-working leader, 'quite
direct, bordering on the blunt'.
The other key senior Goldman executive is COO Thain-- the back room strategist. Paulson
and Thain are all products of Goldman's legendary tight-knit internal culture. GS is renowned
for being conservative and secret. However, GS is with more of a risk-taking and
entrepreneurial culture with aggressive expansion in the 1980s and 1990s.
GS Chairman and CEO
‘Mr. Paulson has been Chairman and Chief Executive Officer of The Goldman Sachs Group,
Inc. since May 1999. He was Co-Chairman and Chief Executive Officer or Co-Chief
Executive Officer of Group LP from June 1998 to May 1999 and served as Chief Operating
Officer from December 1994 to June 1998
Education: Dartmouth College, Hanover; degree in English Literature from the
University of Illinois (1969); Rhodes Scholarship finalist; MBA from Harvard Business
First job: Henry 'Hank' M Paulson worked as an assistant to the assistant secretary of
defence from 1970 to 1972 and was part of a Defence Department team that analyzed the
ailing Lockheed Corporation
Moving on up: Paulson transferred to President Richard Nixon's Domestic Council in
April 1972, working as a staff assistant on domestic policy. He rose to become assistant
director of the Domestic Policy Council. As the Watergate scandal enveloped the Nixon
administration, Paulson left to join Goldman Sachs in January 1974. After a year at
Goldman's New York HQ, he moved to the bank's office in Chicago, his hometown. He
became a Goldman partner in 1982, a regional head of investment banking the following
year and managing partner of the Chicago office in 1988. Paulson was promoted to co-
head of Goldman's investment banking division and given a seat on the management
committee in 1990. He became vice chairman - and second in command to senior partner
Jon Corzine - in September 1994 and was promoted to co-chief executive and co-
chairman alongside Corzine in June 1998. He took over as sole head of the company on
the latter's departure in mid 1999.
Paulson became second in command at Goldman Sachs - as vice chairman, working with
senior partner Jon Corzine - in September 1994 at a time when the bank was in considerable
turmoil. The firm suffered big trading losses in the bond crash that year, a number of partners
left and staff were laid off. But Corzine and Paulson turned Goldman round, so that in the
fiscal year to November 1997 it was able to post record pre-tax profits of $3bn.
Paulson received more than $25m in 1999, plus $5m from personal investments in Goldman's
merchant banking deals. This pay cheque reflected the firm's successful year - as well as the
initial public offering (IPO) that raised $3.65bn, Goldman reported pre-tax profits of $2.7bn
and topped the investment banking industry global mergers and acquisitions advisory league
table, with involvement in 417 deals worth more than one trillion dollars.
A quintessential old-style Goldman banker, Paulson is known for being intensely hard-
working - although he says he has never prided himself on trying to work more hours a day
than anyone else.
Paulson has always kept a low profile, except among the legions of corporate executives he
has advised over nearly 25 years. During his time in the Chicago office he built a reputation
as a good client relationship man.
He has a reputation for being tough where necessary and cracking the whip on younger
associates. He himself has admitted to being 'quite direct, bordering on the blunt', but also
reckons he is 'always very respectful, substantive.’
c. COO and President—Next CEO?
Mr. Thain has been President and Co-Chief Operating Officer of The Goldman Sachs Group,
Inc. since May 1999. He was President of Group LP from March 1999 to May 1999 and Co-
Chief Operating Officer from January 1999 to May 1999. From December 1994 to March
1999, he served as Chief Financial Officer and Head of Operations, Technology and Finance.
From July 1995 to September 1997, he was also Co-Chief Executive Officer for European
Mr Thain was the youngest partner of Goldman Sachs before its 1999 IPO and deemed a
spokesman for young generations in Goldman Sachs. He is only below Paulson and
recognized as the most possible CEO after Paulson’s retirement.
d. Vice Chairman—Next COO and President?
Mr. Blankfein has been our Vice Chairman since April 2002. Mr. Blankfein has management
responsibility for the Fixed Income, Currency and Commodities Division (FICC) and the
Equities Division. Prior to becoming Vice Chairman, he had been Co-Head of FICC since its
formation in 1997. Previously, he headed the J. Aron Currency and Commodities Division
since 1994. Mr. Blankfein has been nominated to serve as director of Goldman Sachs and is
not on the board of any other public companies.
Where do they want GS to go?
GS ever encountered a huge loss before its 1999 IPO and its CEO Friedman was forced out as
a result. Lots of partners left GS and joined other wall- street firms at that time. Due to GS
current global- scale, it is difficult to keep a GS traditional management structure—a banker
plus a trader (since they would not know each other’s business well). Current CEO, Mr
Paulson will retire probably several years later and hand the firm to Mr Thain, both of them
are conservative man, with priority on risk control and most profitable niche market. If there
would be a sequence of priority for GS, it would be ‘customers, reputation, and employee’.
It is predictable GS would continue its current management style, with emphasis on
profitability and risk control, as well as corporate culture.
We think GS revenue would increase 12%-14% annually from 2003-2005 and its new profits
would come from areas such as fixed income trading and asset management. Revenues in
traditional I-banking will not increase much due to the price deduction and global
overcapacity. More risk-control experts will be recruited.
Hedge funds clients and extremely wealthy personal clients will be exploited more.
I-banking would find its profits in Asia and other emerging economies.
GS Return on equity would be 12% or so annually for shareholders in the next three years.
Attachment 4: Goldman Sachs IPO in 1999
‘On May 4, 1999, Goldman Sachs ended its 130-year old partnership and went public with an
initial public offering (IPO) of 6.9 million shares. Demand for shares was so strong that the
IPO trading opened more than an hour late. At the close of trading, Goldman shares settled at
$70 3/8, up 33% over the offering price of $53, making the market value of Goldman around
$33 billion. Reinforcing its reputation for market timing, Goldman priced its IPO on the day
the Dow broke 11,000. The IPO raised $3.7 billion and was the second-largest in history
behind Conoco Inc's $4 billion IPO on 1998.
Once the largest remaining securities firm run as a partnership, Goldman's success is reflected
in its 1998 pretax profits of $2.2 billion, as well as in its number-one ranking in mergers and
acquisitions , according to Securities Data Co. These earnings cannot be casually explained in
terms of sales and commissions. It is something else: a unity of beliefs, values, and ethics
throughout the entire organization.
Marcus Goldman founded Goldman & Company in 1869. When in 1882 he invited his son-
in-law, Samuel Sachs, to join the firm, the company became Goldman, Sachs. Its first big
corporate deal was an IPO by Sears, Roebuck in 1906. In the late twenties, Waddill Catchings
led Goldman into trading, setting up an investment trust in 1928 which borrowed money to
buy stocks on behalf of its shareholders. After the October 1929 crash, shares that had traded
as high as $326 were trading at $1.75, Catchings was forced out, and Goldman's reputation
was in ruins. In 1930, Sidney Weinberg took over leadership of Goldman, which he retained
until 1969. He steered the firm away from business he saw as too risky--making bets with the
partners' capital or managing the public's money--and refocused on advising major
The firm’s partners are its owners and therefore share the firm’s profits. These profits are
distributed to individual capital accounts for each partner. In 1997, each partner’s capital
account rose between $3 million and $25 million, depending upon the number of shares they
owned at year-end. These profits are left in the firm (even for some time after a partner
retires). Therefore, the capital invested during the normal course of business belongs to the
partners themselves, rather than to a corporation or external stockholders. Most partners have
more than 80% of their personal assets tied up in the firm.
In addition to the firm’s partnership structure, the joint leadership of John Weinberg and John
Whitehead was a major influence on its culture. Weinberg and Whitehead had been a part of
the firm since the late 1940s and co-CEOs from 1976 through 1990. Their commitment to
traditions, loyalty to clients, and subordination of their own individual egos through power
sharing and teamwork for the good of the firm worked to generate and maintain the culture
that has been the key to Goldman’s success. Under their tenure, the company displayed a
well-forged emphasis on entrepreneurial aggressiveness, self-effacing teamwork, a shared
knowledge of what the business would and would not do, homegrown talent, and, moreover, a
commitment to serving the customer above all other interests.
After Jon Corzine became Goldman's chairman in 1994, he raised the IPO issue in 1996 in
response to three environmental factors: 1) the bullish stock market, 2) the successful public
stock offering of Goldman’s formerly private competitor Donaldson, Lufkin & Jenrette, and
3) Goldman’s handsome $1.37 billion profit for fiscal year 1995. Both in 1994 and 1996, the
partners opposed the idea. Even Henry "Hank" M. Paulson Jr., the number-2 man at Goldman,
didn't embrace the idea. Corzine eventually gained Paulson's support, some say by agreeing to
make Paulson a cochairman.
In order to keep key staff people Goldman decided to share the proceeds of the IPO in a very
broad manner, unlike many other Wall Street firms that merged or went public. The 13,000
current employees below the level of partner shared a 21.2% stake worth close to $7 billion.
The 221 current partners retained 48.3%, and the 125 retired partners received 8.5% of
Goldman stock. New partners received about $20 million while senior partners received up to
$300 million. However, only the partners' share vested immediately. Employee shares were to
vest over three-to-five years, which should help ensure retention.
Despite the requirements of a public company for public disclosures of its finances, Goldman
is trying to retain as much of its private partnership management style as possible. Its 17-
member management committee remains in charge, although the larger group of former
partners is less powerful now. Also, much of the stock is restricted and can be sold only after
several years. Goldman placed about 70% of the offering with institutional investors they
believed would remain loyal, long-term holders.’
Attachment 5: Selected GS financial Statements (Note 10)
a. GOLDMAN SACHS GROUP INC/ 10-K 2002-11-29: Income Statement
2002/11/29 2001/11/29 2000/11/29
Investment banking $2,572,000,000 $3,677,000,000 $5,339,000,000
Trading and principal investments $4,063,000,000 $6,254,000,000 $6,528,000,000
Asset management and securities $4,950,000,000 $4,587,000,000 $3,737,000,000
Interest income $11,269,000,000 $16,620,000,000 $17,396,000,000
Total revenues $22,854,000,000 $31,138,000,000 $33,000,000,000
Interest expense $8,868,000,000 $15,327,000,000 $16,410,000,000
Revenues, net of interest expense $13,986,000,000 $15,811,000,000 $16,590,000,000
Compensation and benefits $6,744,000,000 $7,700,000,000 $7,773,000,000
Nonrecurring acquisition awards $0 $0 $290,000,000
Amortization of employee initial public $293,000,000 $464,000,000 $428,000,000
offering and acquisition awards
Brokerage, clearing and exchange fees $852,000,000 $843,000,000 $573,000,000
Market development $306,000,000 $406,000,000 $506,000,000
Communications and technology $528,000,000 $604,000,000 $435,000,000
Depreciation and amortization $617,000,000 $613,000,000 $441,000,000
Amortization of goodwill and $127,000,000 $260,000,000 $45,000,000
identifiable intangible assets
Occupancy $637,000,000 $591,000,000 $440,000,000
Professional services and other $629,000,000 $634,000,000 $639,000,000
Total non-compensation expenses $3,696,000,000 $3,951,000,000 $3,079,000,000
Total operating expenses $10,733,000,000 $12,115,000,000 $11,570,000,000
Pre-tax earnings $3,253,000,000 $3,696,000,000 $5,020,000,000
Provision for taxes $1,139,000,000 $1,386,000,000 $1,953,000,000
Net earnings $2,114,000,000 $2,310,000,000 $3,067,000,000
Earnings per share
Basic $4,270,000 $4,530,000 $6,330,000
Diluted $4,030,000 $4,260,000 $6,000,000
Average common shares outstanding
Basic $495,600,000 $509,700,000 $484,600,000
Diluted $525,100,000 $541,800,000 $511,500,000
b. GS 1997-1999
Filing Period 1997/11/26 1998/11/26 1999/11/26
Filing Type 10-K 10-K 10-K
Cash $2,836,000,000 $3,055,000,000
Receivables $4,321,000,000 $4,490,000,000
Total Assets $217,380,000,000 $250,491,000,000
Income Tax Expense
Common Equity $0 $4,000,000
Long Term Debt $48,777,000,000 $61,350,000,000
Total Debt $48,777,000,000 $61,350,000,000
Total Liabilities $211,070,000,000 $240,346,000,000
Retained Earnings $0 $444,000,000
Shareholders' Equity $6,310,000,000 $10,145,000,000
Reverse Purchase Agreements $37,484,000,000
Total Operating Revenue $20,433,000,000 $22,478,000,000 $25,363,000,000
Occupancy Expenses ($168,000,000) ($207,000,000) ($314,000,000)
Interest Expense $12,986,000,000 $13,958,000,000 $12,018,000,000
Income Before Tax $1,992,000,000
Net Income $2,746,000,000 $2,428,000,000 $2,708,000,000
Earnings Per Share: Basic 0 0 5.69
Earnings Per Share: Diluted 0 0 5.57
Depreciation and Amortization $178,000,000 $242,000,000
Operating Activities $70,000,000 $62,000,000 ($12,589,000,000)
Investing Activities ($693,000,000) ($656,000,000) ($654,000,000)
Financing Activities ($258,000,000) $2,102,000,000 $13,462,000,000
Cash at Year Start $2,209,000,000 $1,328,000,000 $2,836,000,000
Cash at Year End $1,328,000,000 $2,836,000,000 $3,055,000,000
Total Employees 15361
FDS (Financial Data Schedule)
Income Pre Extraordinary $1,992,000,000
Long Term $20,952,000,000
Short Term $37,756,000,000
Other Tax 0% 1% 0%
State Tax Net of Fed 3% 1% 5%
Miscellaneous Tax 0.06 0.155 -0.759
U.S. Statutory Rate 35%
(Source: GS Annual Report 2002)
GS Common-Size Balance Sheet
(Use Total Assets as the basis of comparison)
Cash and cash equivalents 1.36% 2.21%
Cash and securities segregated in compliance with 5.73% 7.09%
U.S. federal and other regulations
Receivables from brokers, dealers and clearing 1.63% 1.75%
Receivables from customers and counterparties 6.51% 8.97%
Securities borrowed 31.94% 32.40%
Securities purchased under agreements to resell 12.87% 8.86%
Financial instruments owned, at fair value 34.68% 31.92%
Financial instruments owned and pledged as 1.82% 2.96%
collateral, at fair value
Total financial instruments owned, at fair value 36.50% 34.87%
Other assets 3.46% 3.85%
Total assets 100.00% 100.00%
Liabilities and shareholders equity
Short-term borrowings, including the current 11.43% 12.04%
portion of long-term borrowings
Payables to brokers, dealers and clearing 0.53% 1.29%
Payables to customers and counterparties 26.35% 29.88%
Securities loaned 3.44% 2.20%
Securities sold under agreements to repurchase 16.85% 12.61%
Financial instruments sold, but not yet purchased, 23.48% 23.93%
at fair value
Other liabilities and accrued expenses 1.69% 2.28%
Long-term borrowings 10.89% 9.93%
Total liabilities 94.66% 94.16%
Commitments and contingencies
Preferred stock, par value $0.01 per share;
150,000,000 shares authorized, no shares issued
Common stock, par value $0.01 per share; 0.0014% 0.0016%
4,000,000,000 shares authorized, 515,084,810 and
499,017,511 shares issued as of November 2002 and
November 2001, respectively, and 472,940,724 and
476,228,933 shares outstanding as of November 2002
and November 2001, respectively
Restricted stock units 0.98% 1.45%
Nonvoting common stock, par value $0.01 per share;
200,000,000 shares authorized, no shares issued
Additional paid-in capital 3.59% 3.77%
Retained earnings 2.04% 1.72%
Unearned compensation -0.24% -0.39%
Accumulated other comprehensive loss -0.03% -0.05%
Treasury stock, at cost, par value $0.01 per -1.00% -0.67%
share; 42,144,086 and 22,788,578 shares as of November 2002 and November 2001, respectively
Total shareholders equity 5.34% 5.84%
Total liabilities and shareholders equity 100.00% 100.00%
L1: Brealey and Meyers, (2002). ‘Principles of Corporate Finance 7th edition.’
L2: Jeffrey Hook, (1998). ‘Security Analysis on Wall Street.’
L3: Michael E Porter, (1980). ‘Competitive Strategy.’
L4: Thomson Financial Capital Market Reports, (2002).
L5: Vault Guide to Investment Banking, (2002).
L6: Lisa Endlich, Goldman Sachs, ‘The Culture of Success (1999).’
L7: Richard D. Freedman and Jill Vohr, ‘Goldman Sachs and Lehman Brothers’
New York University Stern School of Business, Revised September 1999)
L8: David Nincic, Wharton 1999, ‘Fundamental Equity Analysis’.
L9: Damodaran, ‘Damodaran on Valuation: Security Analysis for Investment and
Corporate Finance’ 1994 edition.
L10: Robert F. Bruner: ‘Case Studies in Finance’.
Note 1, Source: Finance.Yahoo.com
Note 2, Note 3, Note 7, Note 10, Source: Goldman Sachs Annual Reports
Note 4, Source: www.quicken.com
Note 5, Source: David Nincic, Wharton 1999 and ‘Damodaran on Valuation’ 1994
Note 6: Source: Thomson Financial Capital Market Reports, (2002).
Note 8, Source: www.justpeople.com
Note 9, Source: Richard D. Freedman and Jill Vohr , New York University Stern School
of Business Revised September 1999