Goldman Sachs Isn't as Good as You Think

Is there another financial company discussed in hushed tones the way Goldman Sachs (NYSE: GS) is? Goldman is like the Tiger Woods of the finance world. They both always seemed unbeatable, but now, after certain events, both seem to have a slightly smarmy feel about them.

But Goldman seems to be proving that it will continue pushing forward in the aftermath of the financial crisis and amid a media backlash against the company. After a dismal fiscal 2008 and a systematic burying of its December 2008 results, $13.4 billion in 2009 profits makes it look like the Golden One is back to printing money from the cozy confines of its New York office.

In fact, at this point you might wonder what more there is to say about Goldman. Well, what if I said that Goldman may not be as good as everyone thinks?

Breaking down Goldman's returns
In the precrisis days, Goldman seemed to be raking in absurd sums of money. For many investors, a sign of a well-run business is a healthy return on equity and Goldman was certainly delivering on that front. In 2005, the company's return on ending equity was 20%, bested by the 26.3% performance in 2006, and topped once again by 27.1% in 2007.

An unfortunate fact of life, though, is that sometimes things that look wonderful from afar fail to hold up under closer inspection. Such is the case for Goldman's return on equity.

By using an analytical technique called DuPont analysis, we can break Goldman's return on equity into three parts: operating efficiency, asset efficiency, and financial leverage. Multiplied together, those three components bring us back to return on equity, so if any one piece rises or falls, return on equity moves along with it.

When we break down Goldman's results, it becomes very clear where its juice was really coming from.

Source: Capital IQ, a Standard & Poor's company; and author's calculations.

It's important to remember that while the huge leverage ratios that the investment banks employed during the lead-up to the financial crisis made them very risky, they also gave them impressive-looking returns. In Goldman's case, it never would have achieved those tasty returns on equity had it not sported that lofty leverage ratio.

But what would a lesser-leveraged Goldman have looked like? Not nearly as impressive. Here's a comparison of a bunch of the major financial players if they all had stuck to a leverage ratio of 10 in 2006.

Source: Capital IQ, a Standard & Poor's company; and author's calculations.
Return on equity calculation based on actual profit margin and asset turnover and theoretical leverage ratio of 10.

Goldman may have had company in being overrated (cough, cough, Morgan Stanley), but these results suggest that without leverage, Goldman might as well be Superman sans cape.

You can knock the results
Goldman fans could contest that the DuPont analysis isn't really ideally suited for analyzing finance and banking companies, and they would be entirely accurate. However, it's a pretty weak defense since no matter how you want to cut Goldman's results, a drop in leverage would have cut the knees out from under the company's huge equity returns.

Those fan club members might also point out that 2009's results suggest that Goldman can perform mightily on lesser leverage. To be sure, the company cut down its financial leverage to 12 by the end of '09, and still managed to post an 18.9% return on equity thanks to higher asset utilization and a fatter profit margin.

But I'd question if the Goldman of 2009 is going to be the Goldman of the future. For one, the company cut back employee compensation, particularly in the fourth quarter. This isn't something that I'd rely on for the future, as publicly held investment banks tend to be run primarily for the benefit of insiders. At the same time, it's been a highly favorable environment for Goldman's FICC trading group and there's no telling how long that will last.

As good as gold after all?
Goldman may have come out of the financial crisis smelling like roses when compared to busted competitors like Lehman and Merrill Lynch. However, the company was using massive leverage to juice its results just like everyone else. If you ask me, I think the onus is on Goldman to prove that it's more than just a decent company that was able to borrow a heck of a lot of money a few years ago.

What do you think? Scroll down to the comments section and share your thoughts.

Goldman isn't the only one with a dark secret. Many of the best-performing stocks of the past decade had a dark secret of their own.