Goldman Sachs May Grow by Shrinking: Street Whispers

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.

At a price to earnings ratio of 18, Goldman Sachs currently trades at the highest multiple of its peers. Meanwhile, the bank trades at a discount to its $130 in book value per share, in contrast to the more than two-times premium it traded for before the bust, signaling that investors aren't comfortable with balance sheet driven valuations.

Goldman's authorization to buy back up to 46 million shares in coming years is the most aggressive among its investment banking peers after Morgan Stanley ( MS), Citigroup ( C) and Bank of America ( BAC) didn't submit buyback plans during Fed stress tests and JPMorgan ( JPM) halted a $15 billion multi-year buyback in August after it incurred what stands as a $5.8 billion trading loss.

Since hitting a high of nearly 550 million in shares after taking a $10 billion in Troubled Asset Relief Program funds and $5 billion in emergency capital from Warren Buffett and private investors, Goldman has reduced already reduced its share count by roughly 12% through repurchases.

In line with Goldman's authorization, International Strategy & Investment Group analyst Ed Najarian calculated in August Goldman may yet cut its share count by 11% and putting shares at roughly 434 million. Were Goldman's earnings to stabilize at say $10 billion, slightly above a three-year post crisis average of $8.71 billion, the bank's EPS would come in at above $23, or the average of its 2006 and 2007 results.

Still the risk for Goldman is that ROE remains at the forefront of investor's minds, with the prospect that chief financial officer David Viniar has to continue apologizing for sub-10% returns. In his August note, ISI's Najarian wrote that Goldman is unlikely to earn a ROE over above 10% in coming years, thus warranting a discounted valuation to its book value.

Meanwhile, a September 7 upgrade to Goldman's share price target to $125 by Jeffrey Harte, a principal with Sandler O'Neill hinges on confidence that the bank can post 20%-plus ROE's, without mentioning a forecasted 78% rise in 2013 EPS or the impact of share buybacks.

As investors parse over investment banking names, they may be well served to focus on banks like Goldman with the share repurchase and earnings dynamics that may yield earnings per share growth in coming quarters and years, even if the sector remains constrained by a deleveraging environment that cuts at revenue opportunities and balance sheets.

-- Written by Antoine Gara in New York

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