Goldman Sachs (NYSE:GS) kicked off the brokers' earnings season with its third-quarter earnings announcement on Tuesday. All in all, third-quarter performance looks very respectable, highlighting the strength and diversity of the firm's businesses.

Diluted earnings per share were $3.26, almost unchanged from the prior-year quarter, but ahead of the consensus estimate of $3.10 per share. Goldman beat estimates on the strength of net revenues (after interest expense) of $7.5 billion, up 2% from the previous year. Although all business lines suffered declines compared to the second quarter, remember that the summer is generally a lower activity period for investment banks, and that Goldman's second quarter was the second-best quarter in the firm's history.

The firm's largest segment, Trading and Principal Investments (at 63% of quarterly revenues), posted a 7% decline in net revenues, mostly because of lower gains on its investment in Sumitomo Mitsui Financial Group. The drop was mitigated by strong performances in Investment Banking and Asset Management & Securities Services (providing prime brokerage services to hedge funds), which were up 27% and 20%, respectively. Notably, the firm's underwriting activity showed resilience in a difficult environment, and the Asset Management division recorded strong asset growth. Asset inflows of $30 billion brought total assets under management to $629 billion. Alternative investments, which generate higher fees than traditional investment products, contributed $13 billion to the increase.

Investment banks' personnel are their largest expense by far. Goldman's compensation and benefits expenses for the quarter consumed 47% of net revenues, down from 50%, and lower than the ratio for the first nine months of this year. However, non-compensation expenses rose 29%, versus 2% net revenue growth. Goldman CFO David Viniar simply attributed this to the firm's growth, but it could be worth monitoring for future deterioration.

The flip side of the return coin is risk. Along with many market participants, Goldman reduced its exposure during the third quarter. And although the the firm's VaR (a measure of its maximum one-day loss on its trading positions, with a 95% confidence interval) increased year over year from $76 million to $92 million, once these potential losses are scaled against shareholders' equity, the risk profile is essentially unchanged (based on this single measure).

Goldman Sachs has set the bar high for its peers this quarter. That isn't unusual -- Goldman's first nine months of this year have been outstanding. The market cheered this earnings report, sending the stock up more than 4% by Tuesday afternoon, with the S&P 500 up less than 1%. Still, I can never rid myself of the concern that the firm has greater exposure to the general health of the global economy and markets, because of the breadth of its "own account" activities. While uncertainty regarding the Fed's attitude toward inflation appears to have abated, any number of potential "road hazards" could spring up to test the firm's mettle, much as the 1994 bond market did. It's the only explanation I can find for why this pack leader continues to trade at a below-average earnings multiple.

Earnings Growth (Est. 5 yrs)


Forward P/E

Goldman Sachs


2.2 times

9.0 times

Peer Group*


2.0 times

10.3 times

* Based on closing prices on 9/11/06 for a peer group containing Bear Stearns (NYSE:BSC), Lehman Brothers (NYSE:LEH), Merrill Lynch (NYSE:MER), and Morgan Stanley (NYSE:MS). Average P/BV (book value) and P/E multiples are weighted by market capitalization. Average earnings growth rate is unweighted.

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Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.