5 Years Post-Lehman, Where Do the I-Banks Stand?

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

On the back of a first week of gains for the month of September, stocks are starting this week off on a positive note, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) up 0.47% and 0.55%, respectively, at 10:10 a.m. EDT.

With a military strike on Syria no longer imminent -- President Obama has asked Congress to decide the matter -- and the Fed's rate-setting committee meeting next week, traders are free to focus on other matters for now.

This week will mark the fifth anniversary of the Chapter 11 bankruptcy filing of investment bank Lehman Brothers -- the largest bankruptcy in U.S. corporate history. That event proved to be a turning point in the financial crisis, as the aftershock roiled asset markets worldwide, gravely harming sentiment and knocking an already bruised global economy down further.

Two banks left -- where do they stand?
But today's column is not concerned with sweeping analysis, but rather with a more narrow question: Five years on, what do the remaining independent investment banks, Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) , look like from an investor's perspective?

On the eve of Lehman's bankruptcy, Goldman Sachs shares were valued at 1.81 times their tangible book value, while the equivalent figure for Morgan Stanley shares was 1.4 -- and those multiples had already fallen hard with the onset of the crisis.

As of last Friday's close, the same multiples were 1.11 and 1.02, respectively. Clearly, a post-Lehman discount is still in effect -- and rightly so. Indeed, the banks have been forced to drastically reduce their leverage and, with it, their target returns on equity, which, for Goldman, had exceeded 25% at the peak of the credit boom. Goldman's return on equity for the 12 months ended June 30 was 11.3%.

However, there is a countervailing factor that favors higher multiples: Lower leverage means a stronger balance sheet, which, in turn, reduces the risk associated with owning the common equity (not to mention that banks have made efforts to smooth their earnings volatility). As such, shareholders should apply a lower discount rate (or required rate of return) to the shares, ergo higher valuations.

Between these two forces, how do things pan out today? At 10.6 times the next 12 months' earnings-per-share estimate for Goldman's stock and 11.3 for Morgan Stanley's, I don't think either of them looks particularly compelling or especially expensive. Furthermore, investors ought to remember to apply a "governance discount": Despite some efforts to elevate shareholders' standing, I continue to think these organizations are run mainly to benefit employees and insiders, rather than outside shareholders. Caveat emptor!

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