Dow Picked Goldman Sachs, but Investors Should Pass

NEW YORK ( TheStreet) -- Recently the Dow Jones Industrial Average ( DJIA) removed three stocks from its membership roster and added three new stocks in their place. The stocks that were kicked out: Alcoa ( AA), Bank of America ( BAC) and Hewlett-Packard ( HP). The stocks added: Visa ( V), Nike ( NKE) and Goldman Sachs ( GS).

I wrote about this change in another publication and why, in my opinion, it took so long for Visa to be added. I also analyzed the worthiness of Visa as a Dow member. Ultimately, what I determined is that Visa is a great stock that is worthy of the Dow, and its membership has been a long time in the making.

But what about Goldman Sachs? Why was it finally chosen as a DJIA member and is it actually worthy?

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Goldman Sachs has been around a long time -- since 1869 -- which leads back to my question: Why now, Dow Jones?

Headquartered in New York City with offices in major financial cities across the world, GS is a global investment banking and management and securities firm that provides a varied range of financial services to the likes of corporations, financial institutions and governments, as well as high-net-worth individuals.

GS falls into the financial sector of the market. So far in 2013, the financial sector has had pretty mediocre performance. In fact, currently, I give the financial sector a grade of B-.

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GS is a $75 billion company. It is a large-cap stock. Large-cap stocks also have had pretty mediocre performance in 2013. Currently, the large-cap stock asset class gets a grade of B.

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GS is a stock geared toward conservative risk-profile investors.

Before I get started on my analysis of GS, let me share my method of madness on how I rank stocks. I separate them from one another by taking into account the following criteria:

  1. Performance: Short term, intermediate term and long term where possible. I compare the performance of the stock with its peers and against the other 3,565 stocks that I monitor.
  2. Valuation: While I like performance, I have seen way too many momentum darlings come crashing back down to earth due to astronomical valuations. We have learned huge valuation lessons from incidents like the crash of the Nasdaq in 2000-2001, the crash of the housing market in 2006, and many other such bubbles. Valuation does matter!
  3. A healthy stock chart: I don't like sideways trends (Apple would be a good example of this), I despise downtrends (Inverse ETF's would be a good example of this) and I get very nervous with extended uptrends, unless the valuation is still compelling. And of course, the most dangerous trend of all is a topping-out trend that is beginning to roll over.


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Let's start with performance of the stock. Again, I look at short-, intermediate- and long-term performance.

Over the last 10 years, GS has delivered 8% per year to investors while the market has delivered 5%.

Over the last five years, they've delivered 6% per year, while the market has delivered 8% during the same time frame.

Over the last three years, GS has delivered 4% per year to investors while the market has delivered 14%.

Over the last 12 months, GS is up 41%, while the market is up only 17%.

When I rank the performance of Goldman Sachs against the other 3,500 or so that I follow, it only earns a performance grade of C.

That sound pretty average to me. How can you expect above-average returns with average stocks?

In my opinion, GS is NOT worthy of your investment based on performance.

Now, onto valuation.


Although I do like to see momentum, I'm not solely a momentum investor. Nor am I a pure value investor. I like to combine momentum with value.

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The consensus analysts' estimates for GS's earnings next year currently stand at $15.44 per share. The consensus average five-year earnings growth estimate for GS is 5.3% per year. Given these expectations, the shares currently sport a PEG ratio of 1.95. PEG ratio is just one valuation measure, however.

When we take that estimate of $15.44 per share and extrapolate it out over the next five years, we come up with potential earnings per share of $18.75, five years from now.

Now we need to apply an appropriate multiple to those earnings to project a five-year target price. This is the hardest part of the equation. There is no set rules to go by here. Instead, we must weigh the following factors in determining the multiple:

  1. The current forward average PE ratio of the 3,565 stock that I track is currently 19.8.
  2. The current forward PE of GS is 10.25.
  3. The current average forward PE for the group is about 13.
I am using a very conservative multiple of 13 on the potential future earnings of the shares. When I do this I come up with a five year target price of $252 per share. The stock is currently only trading at $158.

With the shares currently trading around $158 per share, this stock has the potential to go up about 65% over the next five years. However, I require at least 80% upside potential or more to meet my strict valuation criteria. GS currently does not meet that requirement. It gets a value grade of C-.

There is obviously a lot that can go wrong or go right between now and then. And as we can see from the recent spike in GS' performance, stocks trade on expectations. And right now the expectations of other analysts are obviously positive because the stock was added to the Dow and Goldman has made a pretty good recovery coming out of 2009.

Those expectations will change with each quarterly report and any material news, good or bad, that comes out of the company.

The stock price will then adjust accordingly.

Stock Chart

So far, GS' performance and valuation does not look good, but let's complete that last step in analyzing GS' worthiness as a Dow member. Check out that stock chart:

Despite GS' rather dismal performance and valuation, I see a stock that is in a pretty good uptrend. I currently own a lot of stocks that have much better charts, however.

GS is currently a laggard sector of the market (financial).

GS currently does NOT meet my performance criteria.

GS currently does NOT meet my valuation criteria.

GS currently DOES barely meet my stock chart criteria.

Of the 3,656 stocks that I track, GS currently comes in only at #2,321 with a Gunderson stock grade of B-. I only consider stocks that have a combined grade of A- or better.

And while the Dow may have selected Goldman Sachs for its 30 stock portfolio, individual investor should pass.

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I am very vigilant on a daily basis on the stocks that I own. At the current time, clients of Gunderson Capital Management are not long the stock.

Please follow me on Twitter @billgunderson to check new opinions of the stock.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.