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Morningstar | Goldman Sachs Is Still in the Early Stages of a Transformation

Narrow-moat Goldman Sachs' third-quarter results were relatively strong, but metrics are mixed regarding how much its business model has changed in recent years. The company reported net income of $2.45 billion, or $6.28 per diluted share, on $8.6 billion of net revenue in the third quarter. Net revenue increased 4% from the previous year's third quarter, but was 11% lower than the strong, first half of 2018 average. For the first nine months of the year, Goldman Sachs had a 14.6% return on tangible common equity, which is quite strong. That said, we're likely closing in on the peak of this capital market cycle and it's yet to be seen if enough of the company's $5 billion net revenue initiative will be realized to offset a cyclical downturn. We don't anticipate making a material change to our $258 fair value estimate for Goldman Sachs and view shares as fairly valued to modestly undervalued at current prices.

The company remains in the early stages of its $5 billion initiative and in a transformation that will tilt the business a bit more in the direction of technology capabilities and away from human capital. So far, the most concrete figures that track toward the company's $5 billion goal is the increase in net interest income in the investing and lending segment to approximately $700 million in the quarter from $450 million a year ago, which can be partly tied to the company's increase in loan originations and deposit gathering. While the company has assigned investment banking coverage responsibilities for about 80% of the companies that it's targeting, it can take a year for those bankers to ramp and generate revenue. For other business lines like trading and investment management, gains in share can be as much happenstance as due to management actions.

Goldman Sachs has been spending a bit more of its time talking about the importance of its technology and platforms and that looking at the bank's total expense ratio may be more useful than focusing attention on the compensation ratio. If Goldman Sachs were to transform into a more technology-driven business, such as running trading platforms like a stock exchange as opposed to having voice brokers, it would make sense to look at the total expense ratio instead of the compensation ratio. That said, the company's compensation ratio has been fairly steady since 2012 in a range of about 37% to 38%. This is a large decrease compared with 44% to 46% before the financial crisis, but not much change lately.

In a firm that generates more revenue from technology investments than human capital, we might also expect revenue per employee to increase. However, since 2012, revenue per employee has generally been on a downward trend from approximately $1.05 million per employee to slightly below $900 thousand in the two previous years. On a per employee basis, compensation and benefits expenses has trended down to about $324 thousand in 2017 compared with $400 thousand in 2012. This could be evidence of an increase in technology workers compared with bankers, but also just be related to the locations where Goldman Sachs is recruiting employees. Overall, most signs point to Goldman Sachs still being in the earlier part of its $5 billion, net revenue growth initiative and that it's still as much of a human-capital business as a technology business.