Goldman’s Upside/Downside to Stock Price From Trading Unit

Goldman Sachs (NYSE:GS) is a leading global investment banking, securities and investment management firm that provides a wide range of financial services to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals. It competes with Morgan Stanley (NYSE:MS), JP Morgan (NYSE:JPM), Credit Suisse (NYSE:CS), and UBS (NYSE:UBS).

We estimate that bonds, currencies & commodities trading constitutes around 37% of our $167 price estimate for Goldman’s stock, with equities trading accounting for around 17%. Our price estimate is roughly inline with the current market price.

Trading Under Pressure

Of the financial bellwethers, the picture has been mixed so far as JP Morgan reported strong earnings but Citigroup missed on account of poor trading revenues. Citigroup blames tight credit spreads which is due in part to a historically flat yield curve and loose monetary policy which makes trading more difficult for many fixed income traders. (See Trefis article: Declining Fixed Income Revenues Could Spell Downside for Citigroup Stock).

In addition to this, fixed income trading has been down due to sovereign debt risk and interest rate volatility in Europe. While Goldman is the gold standard in the trading business, with its fixed income, currencies & commodities trading (our bonds, currencies & commodities division) being one of the most profitable in the industry, the macro environment has a been difficult one for trading in the last half of the year. Given Goldman’s reliance on its trading and market making business, many feel that Goldman will be one of the worst banks impacted by the Volcker rule. ^[1]

The trading assets for bonds, currencies & commodities increased from $220 billion in 2005 to $320 billion in 2007 but then fell to $270 billion in 2009 due to the economic downturn. With the economic recovery in swing, we expect it to gradually increase to around $300 billion by the end of our forecast period. However, the regulatory issues and volatile trading environment may provide downside risk to our estimates. If the trading assets for Bonds, Currencies & Commodities falls to around $240 billion by the end of our forecast period, it would mean around 7% downside to our current price estimate for Goldman’s stock.

Overhangs in the Open Now, Could Lead to Upside

However, the financial sector appears to be in much better shape entering 2011 than 2010. Not only is the macro economic picture much better but many of the regulatory unknowns that served as an overhang are now at least out in the open. We expect that banks like Goldman Sachs and Morgan Stanley, that depend more on trading and investment banking for revenues will be forced to adjust their operations with the rulings out there in the open. As an example, both Morgan Stanley and Goldman Sachs are looking to spin off units of their proprietary trading business, and Goldman is changing its reporting structure to increase the transparency of its proprietary trading business. These factors could add some visibility to the stocks and help both the banks and their investors focus on other issues than government regulations.

The yield on trading assets for bonds, currencies & commodities has been following an increasing trend historically with the only correction being in 2007 and 2008 due to the economic downturn. We expect the yield on trading assets for bonds, currencies & commodities, which was nearly 9% in 2009 to follow a decreasing trend reaching 5% towards the end of the Trefis forecast period. If the decrease is less than we expected 6% by the end of our forecast period, it would mean around 7% upside to our current price estimate for Goldman’s stock.

See our full analysis of Goldman Sachs here.

1. JP Morgan Downgrades Goldman Sachs on Volcker Rule [↩]