Goldman Sachs is a high quality cheap stock...

Goldman Sachs is not a company that needs an introduction.  Here is a description:

"The Goldman Sachs Group, Inc. is an investment banking, securities and investment management company that provides a range of financial services to corporations, financial institutions, governments and individuals. The Company operates in four business segments: Investment Banking, Institutional Client Services, Investing & Lending, and Investment Management. The Investment Banking segment consists of financial advisory and underwriting. The Institutional Client Services segment makes markets and facilitates client transactions in fixed income, equity, currency and commodity products. The investing and lending activities, which are typically longer-term, include its investing and relationship lending activities across various asset classes, primarily debt securities and loans, public and private equity securities, infrastructure and real estate. The Investment Management segment provides investment and wealth advisory services. As of December 2016, it had offices in over 30 countries."

Goldman announced quarterly results last night and the stock sold off based on tepid growth in various business lines.  Short term disappointment really.  That's not what this note is about.  I have no idea what the short term holds for the global economy or Goldman Sachs.  My goal is to discuss the quality of Goldman's earnings, and also the low multiple it currently trades at.  I'm going to argue it deserves a higher multiple.

Let's look at how Goldman Sachs has done over the last few years.  From the 10K: 

2016: $30.6 billion in revenues, $10.3 billion pre-tax net earnings
2015: $33.8 billion in revenues, $8.8 billion pre-tax net earnings
2014: $34.5 billion in revenues, $12.4 billion pre-tax net earnings

There are a lot of moving parts underlying this, as Goldman Sachs is a big diversified business.  Granted it is a financial services company and all its business lines are correlated to economic activity to a great extent, it still is the life blood of the global economy through its various business lines.  Goldman Sachs is a brokerage and partakes - in a similar spirit to Visa and MasterCard - in a large swathe of economic activity.  Anyone who has been investing for any significant period of time will tell you that you do not generate pre-tax net income margins of 35% without offering a very valuable service.  These margins are very juicy in the world of investing.  Any investor will take note.

Let's quickly look at what this high quality business is valued at right now: $90 billion.  So last year, GS did $7.3 billion of net income after tax.  Analysts are projecting 2017 E at $7.9 billion.  So 11X NTM EPS.  Is that cheap?  The answer is complicated.  I believe so.  I think 15X is more fair, since I believe Goldman is likely to continue to compound bottom line EPS nicely over the next few years.  Of course, this relies on steady economic growth, and an acceleration would be even better, but economic growth is largely unpredictable, so there is very little point in discussing it.

Back to the P/E multiple.

P/E multiples don't mean anything.  Stocks can trade at 1000X NTM EPS (e.g. Netflix, Amazon at one point historically) or 2X NTM EPS (e.g. Valeant, Endo currently).  What is required is that the P/E multiple is paired with a deeper understanding of the underlying dynamics of the business.  This means we have to understand the moat around the business, sustainability of earnings, the cost of capital, competition, potential cyclicality, potential for technological disruption etc.

Ben Graham has a great quote on this front: "You don’t have to know a man’s exact weight to know that he’s fat.”
Amazon and Netflix are valuable enterprises.  Are they worth $400 billion or $60 billion respectively?  I have no clue.  But they are valuable, given the service they provide, the durability of their moat, and their customer focus.  Valeant and Endo are debt laden enterprises that offer ordinary products at prices that arguably are inflated.  (To be sure, Valeant does own Bausch & Lomb, which is a high quality consumer products company).  But neither Valeant nor Endo are particularly valuable, apart from the once popular carry trade both were able to implement thanks to a conducive drug price environment.  You don't have to know a man's exact weight to know that he's fat.

Back to Goldman Sachs.  Goldman Sachs is a high quality company.  While it is not a bank, Goldman does have leverage due to the financial intermediary and balance sheet heavy nature of its business.  This is not a capital light business by any means.  While this is not ideal (since leverage almost always results in some crisis at some point in the life of a business), the core operations are a necessary evil for the modern economy to operate.  Obama really captured the essence of Goldman Sachs' business during the  annual White House Correspondents Dinner

“All of the jokes here tonight are brought to you by our friends at Goldman Sachs,” Mr. Obama said, referring to the SEC allegations. “So you don’t have to worry — they make money whether you laugh or not.”
And that is important. 

Goldman makes money as long as the economy functions.  It makes more money as the economy grows.  11X for a company earning 35% pre-tax margins is too cheap in my opinion.  Granted we could see an economic slowdown, or muddling growth, and in that case Goldman Sachs' stock will fall, just like almost every other company.  But if you look at Goldman's business, it is a high quality service oriented one.  Goldman is also buying back stock at these prices, so that's a nice return of capital at a low multiple.

So maybe Goldman Sachs doesn't deserve a 24X multiple like Visa.  But it does deserve a better multiple than 10-11X, especially since if we do see rising rates and a faster growing economy, EPS will compound very nicely over the next few years.