Investment banks have become synonymous with shady deals and back-office shenanigans, but they are a central force to growth in the economy, and like most things in the world, not all investment banks and bankers are bad.<\/p>\n\n\n\n
With the recent IPO of Snowflake (SNOW<\/a>) and the frothiness of the public offering, I thought it would be a great time to examine investment banks such as Goldman Sachs (GS<\/a>) and Morgan Stanley (MS<\/a>), which were the banks that enabled Snowflake to go public.<\/p>\n\n\n\n In today\u2019s post, we will discover:<\/p>\n\n\n\n Ok, let\u2019s dive in and learn more about investment banks and investing in their stock.<\/p>\n\n\n\n\n\n\n\n An investment bank, according to Corporate Finance Institute<\/a>:<\/p>\n\n\n\n \u201cInvestment banking is the division of a bank or financial institution that serves governments, corporations, and institutions by providing underwriting (capital raising) and mergers and acquisitions (M&A) advisory services. Investment banks act as intermediaries between investors (who have money to invest) and corporations (who require capital to grow and run their businesses).\u201d<\/em><\/p><\/blockquote>\n\n\n\n Investment banks function on two levels, as an investment bank and investment banking divisions of a bank.<\/p>\n\n\n\n Full-service banks such as JP Morgan offer a wide range of services such as deposits, credit cards, mortgages, investments, and wealth management. Typically, a full-service bank such as JP Morgan also contains an investment banking division that allows it to undertake the roles an investment bank offers.<\/p>\n\n\n\n On the flip side, a full-service investment bank offers services such as underwriting, M&A, sales and trading, asset management, equity research, commercial banking, and retail banking.<\/p>\n\n\n\n JP Morgan offers all of the above services, including services available at Goldman Sachs. The investment bank focuses its offerings to those services. Investment banks do offer retail services, but they are more an afterthought in their business.<\/p>\n\n\n\n Investment banks typically focus on two areas:<\/p>\n\n\n\n More detail on the services offered at investment banks:<\/p>\n\n\n\n Investment banks operate with two main businesses:<\/p>\n\n\n\n The focus of most investment banks is the two above services, and in this section, we will examine both in some detail.<\/p>\n\n\n\n Underwriting<\/strong><\/p>\n\n\n\n Underwriting is the process of raising capital for a company through the sale of stocks or bonds, also known as an IPO (initial public offering) on behalf of the company in question.<\/p>\n\n\n\n Companies need cash to function and grow their businesses, and an investment bank helps the company raise that capital by marketing the company to investors, either individuals or institutions.<\/p>\n\n\n\n To do this, investment banks use three types of underwriting:<\/p>\n\n\n\n Once the company decides which IPO offering to undertake, the next step is for the investment bank to build a plan to price and market the IPO.<\/p>\n\n\n\n The typical pattern the banks follow is:<\/p>\n\n\n\n The sell-side analysts are responsible for setting the pricing of the IPO, and they use fundamental analysis to achieve that goal, which means examining the financial details of the company to decide on a fair price.<\/p>\n\n\n\n However, the sell-side analysts are in a difficult position because they are writing about companies that are also the bank\u2019s best customers, and the investment banks generate HUGE<\/strong> fees from IPOs, which we will discuss in a moment. Therein lies some of the issues with sell-side analysis and why we must take most of their reports with a bit of skepticism.<\/p>\n\n\n\n Mergers and Acquisitions<\/strong><\/p>\n\n\n\n Mergers and acquisition is the process of helping businesses find others to either find, evaluate, and acquire other businesses. Along with IPOs, this is a key function of investment banks.<\/p>\n\n\n\n Banks such as Goldman Sachs use its extensive networks and relationships to find many opportunities for its clients and enable those transactions to happen.<\/p>\n\n\n\n Investment banks can play both sides of the merger, the \u2018buy-side\u201d or the \u201csell-side\u201d of the deal.<\/p>\n\n\n\n There is a ten-step process followed for any merger or acquisition:<\/p>\n\n\n\n Now that we understand a few of the big jobs that investment banks undertake, who needs these types of services, certainly not little old me.<\/p>\n\n\n\n Investment bank clients include:<\/p>\n\n\n\n Some of the main players in the investment banking world:<\/p>\n\n\n\n Keep in mind that this list contains some of the bigger names, but there are a host of smaller, mid-region banks that offer these services, plus boutique investment banks that make up a large part of the market.<\/p>\n\n\n\n Unlike more traditional banks, much of the income investment banks earn come from:<\/p>\n\n\n\n Let\u2019s examine a real investment bank, Goldman Sachs, one of the more infamous banks out there. The company has a long history in finance and is thought of as one of the premier banks out there.<\/p>\n\n\n\n Goldman Sachs organizes its business into four different segments and divides its income statement accordingly:<\/p>\n\n\n\n Let\u2019s look at the importance of the revenues and how they rank in importance to the bank over the last few years, for reference.<\/p>\n\n\n\n Along with the above fees and monies that Goldman made, there is also the matter of the loans the banks make and the interest it generates from those loans.<\/p>\n\n\n\n Along with the above chart of revenues, the bank also generates money from those loans.<\/p>\n\n\n\n To put these in comparisons to overall revenue so we can understand the relation to operations for 2019.<\/p>\n\n\n\n If you compare those percentages to the traditional bank, you will see that the majority of the income of Wells Fargo comes from interest income, wherefrom Goldman Sachs is only approximately 12%.<\/p>\n\n\n\n But as with any bank, the balance sheet must be our focus when looking at the financial strength of any bank.<\/p>\n\n\n\n The breakdown of assets for Goldman is different than say, JP Morgan or Wells Fargo. For example, loans as a percentage of assets are 10.9% and 14.6% for Morgan Stanley, compared to the percentages of Wells Fargo at 50.6%, and JP Morgan of 35.2%.<\/p>\n\n\n\n And likewise, with deposits being a liability, Goldman Sachs has 209% of deposits as liabilities, with JP Morgan having 64.4% of its liabilities as deposits.<\/p>\n\n\n\n Also, investment banks carry more long-term debt than traditional banks, as evidenced by the 22.9% of long-term debt to liabilities for Goldman Sachs, compared by the 12.1% of JP Morgan.<\/p>\n\n\n\n All of which tells us that investment banks are a little less efficient than traditional banks because they carry more long-term debt. Investment banks are more reliant on debt for their business than Wells Fargo.<\/p>\n\n\n\n Let\u2019s look at the balance sheet of Goldman Sachs to get a flavor of the balance sheet versus a traditional bank.<\/p>\n\n\n\n Notice under the asset section, the number of trading securities, especially compared to the total amount of assets. And likewise, securities and long-term debt comprise the majority of the liabilities of Goldman Sachs.<\/p>\n\n\n\n Now that we understand the financials a little bit and how they differ from traditional banks, let\u2019s look at the process of analyzing an investment bank.<\/p>\n\n\n\n Investing in investment banking stocks is a process similar to traditional banks; many of the same strategies and processes are similar, such as using relative metrics like the P\/E ratio and price to book.<\/p>\n\n\n\n Let\u2019s start with the relative valuations; for a bank like Goldman Sachs, using relative metrics is a great way to determine the valuation quickly.<\/p>\n\n\n\n For example, the current TTM (trailing twelve months) PE for Goldman Sachs is 14.70, based on their second-quarter 2020 results. When you compare that ratio to the sector ratio median of 11.1, it appears that Goldman is a little too expensive at this time.<\/p>\n\n\n\n Moving on to the P\/B ratio, which is currently 0.89 on the TTM numbers, compared to the sector median of 0.82, it again appears overvalued. But when you compare the ratio to Goldman\u2019s five year average of 1.06, it looks undervalued.<\/p>\n\n\n\n Next, let\u2019s analyze the company on a profitability basis using some of our old favorites, return on equity,<\/a> and return on assets<\/a>.<\/p>\n\n\n\n Looking at the current return on equity for the TTM basis, Goldman is at 6.60%, compared to the sector median of 8.1% and the company\u2019s five year average of 8.76%, all of which indicates that Goldman is less profitable than both its sector and historical performance.<\/p>\n\n\n\n Using the return on assets for the TTM tells the same story as the current level is 0.47%, below the sector median of 0.86%, and its five year average of 0.77%.<\/p>\n\n\n\n All of these numbers tell a story. The story they appear to tell us is that the company is expensive based on a relative basis and that it is underperforming from a profitability basis.<\/p>\n\n\n\n Now, none of these are indications of the business failing, rather more of an indication of underperformance compared to its market price. What are the reasons for that underperformance? That is is the fun of putting on our Sherlock Holmes hat and investigating why.<\/p>\n\n\n\n Many of the methods we use to analyze traditional banks<\/a>, such as looking deeper at the loan portfolio and deposits, are not available to use because of the nature of the business of investment banks and metrics like the efficiency ratio<\/a> are not as useful. However, the recent two quarters have posted efficiency ratios of 73.9% for Q1 2020 and 63% for Q2 2020.<\/p>\n\n\n\n Rather, using relative metrics such as the ones above helps determine the value of the bank and the profitability of the bank from its investments. Because Goldman divides its revenues into separate segments, I highly recommend you browse through the management discussion<\/a> related to the segment performance as they will highlight the performance of each segment.<\/p>\n\n\n\n For example, in the notes section 25, we can see the return on equity for each segment outlined by the bank.<\/p>\n\n\n\nWhat is An Investment Bank?<\/h2>\n\n\n\n
How Does an Investment Bank Work?<\/h2>\n\n\n\n
Understanding the Financials of an Investment Bank<\/h2>\n\n\n\n
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<\/a>Click to zoom<\/code><\/figcaption><\/figure><\/div>\n\n\n\nHow to Analyze an Investment Bank<\/h2>\n\n\n\n