For today's Rule Maker, I examined investment services companies Goldman Sachs (NYSE: GS). The worsening economy led investors to sell off shares of financial services companies and we wanted to see whether the exodus produced any obvious opportunities. We began our review last week with a look at Citigroup (NYSE: C), and tomorrow, Mike Trigg will conclude with Morgan Stanley (NYSE: MWD).

Goldman Sach's has three primary business: Investment banking, trading and principal investments, and asset management. Investment banking, services such as equity underwriting, represented 32% of net revenues last year. Trading and principal services, such as bank loans, commodities and currency trading, represented 40% of net revenues, and asset management, services such as mutual funds and the like, represented the rest. You can see the company's revenues are well distributed among its different businesses.

Of course, the last few years have been great times for investment services companies. Goldman's net revenues grew 40% annually from 1998 through 2000. Assets under management grew 29%. Last year the company lead the industry in high-margin mergers and acquisition advisory services.

Things changed quickly once the economy slowed, of course, and investment services companies, whose bread and butter is services such as equity and debt underwriting deals, felt the heat quickly. Just look at what's happened in the merger and acquisitions and equity underwriting business over the last year.

In global mergers and acquisitions, industry proceeds for the first six months of 2001 dropped to $71.7 billion on 928 issues, compared to $290.2 billion on 1,363 issues last year, according to the IDD.

Through the first six months of 2001, there were only 41 new equity issues worth $17.5 billion, compared to 144 worth $60.4 billion a year ago, according to the Investment Dealers' Digest. The business is down by more than two-thirds and there's no sign of things improving.

Now investors are seeing why investment services companies like Goldman are awarded fairly modest price earnings ratios despite a great brand name and rapid growth potential. The investment services business is cyclical.

In the Rule Maker, we're not too concerned about the cyclical nature of the business, but it's important to understand the market typically caps the value of highly cyclical companies. The market didn't fail to award Goldman a much higher multiple in 1999 and 2000 because investors weren't paying attention, but because the market understands the boom and bust nature of the business.

Despite the ups and downs of the industry, Goldman is well positioned. Analysts expect the demand for investment banking services in Europe to grow rapidly in the long term. This is why Citigroup expanded its investment banking division, Solomon Smith Barney, with the $2.2 billion purchase of United Kingdom investment bank Schroders last year. Goldman is one of the leading investment banks in Europe -- about 35% of its employees are based overseas. Last year, only Morgan Stanley acted as underwriter in more European M&A deals than Goldman. (This year is a different story, with Goldman in sixth place according to a First Union research report.) 

Also, Goldman's assets under management have grown steadily, even in weak markets of late. As of May, Goldman's assets under management had grown 14%, while assets under management at T. Rowe Price (Nasdaq: TROW), a company we own in this portfolio, fell 11.4%.

Looking at a few rule-of-thumb valuation measures, Goldman's shares have become more attractive over the last two years. (The company didn't go public until May 1999).

Goldman Sachs      Current    2000    1999 
Forward PE          16.28     17.82   16.41  
Price to sales       2.05      3.13    3.32       
Price to book value   1.9      3.13    4.37

But based on this, I see the company trading at about fair value, slightly higher than the typical investment banking company, but nothing like the kind of discount you might think would be available given the stock's slide.

Have a great day.

Richard McCaffery doesn't own shares of any company mentioned in this report. The Motley Fool is investors writing for investors.