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Goldman Sachs May Grow by Shrinking: Street Whispers

Stocks in this article: GS BAC MS JPM C

NEW YORK ( TheStreet) -- Goldman Sachs (GS) wants to get its stock back to pre-financial implosion levels. But rather than planning to boost shares in ways that earned the bank its "Vampire Squid" moniker, Goldman may be looking to pull a market slight of hand by buying back stock and reducing its public float to match a post-bust earnings outlook.

The investment bank has been apologizing lately to shareholders about its single digit return on equity (ROE), a measure that tells how fast the bank can grow its accumulated earnings.

"While we're trying to pare down and perform as well as we can in this difficult environment, these aren't returns that are acceptable to us or to our shareholders, and we know that," David Viniar, Goldman's chief financial officer, said of the bank's ROE in a July earnings call.

Goldman's ROE sits at 8.8% midway through 2012 compared to ROE's of over 30% in pre-crisis boom years. Getting that figure higher is seen as a key to lifting Goldman shares from $115 to its pre financial crisis highs above $220.

Pushing the stock to those levels using ROE; however, is near impossible considering both the bank's transformed business model in the wake of the bust and Federal Reserve mandated standards on capital. Crucially, both realities will keep a lid on leverage - a key element of financial sector ROE's prior to the crisis.

But Goldman's announced program to buy back up to roughly 11% of its outstanding shares in coming years may be the best hint for how the bank is gearing to return to pre-crisis earnings and valuations. By reducing its share count, Goldman may be smoothing a new path towards earnings records and a share price boost, this time focusing on earnings per share over ROE.

Consider that ROE represents the rate of gains on a bank's reinvestment of shareholder equity and is colored by leverage ratios as much as it is by earnings. For instance, Goldman's record 2009 earnings of $13.4 billion yielded a ROE of just 21.8%, according to Bloomberg data, compared with 30% plus levels in 2006 and 2007.

The reason? Goldman boosted its tangible common equity by over 70% to move past the crisis.

When investment banks were in the business of making directional bets on asset prices - called proprietary trading - and bundling up mortgages in the securitization market, balance sheet driven metrics like ROE made more sense. Now that Goldman's balance sheet is comprised of 93% liquid investments that fuel its market making and underwriting operations, according to a July Fixed Income Investor Presentation, earnings per share flows may be more appropriate.

By way of EPS, Goldman Sachs already has the brightest prospects of any U.S. investment bank, and its share buyback objectives give investors a new and predictable reason for optimism.

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