Warren Buffett's Investment in Goldman Sachs

Warren Buffett, CEO of Berkshire Hathaway, continues to use his firm's enormous cash reserves to make purchases into some of the most valued, but down trodden, American companies. Buffett declared another deal this week, the first week of October, 2008: He's purchasing $5 billion worth of perpetual preferred stock in Goldman Sachs (NYSE:GS), plus an option to buy at a greatly discounted rate for the next 5 years.(. Buffett will get a 10% dividend and the stock is callable after three years at a 10% premium.

As arguably the world's greatest living investor, Buffett's investment moves are always watched by the public and news media. When Buffett invests in a firm, like Goldman Sachs, it's a very valuable endorsement. This time it's an endorsement of not only this company but the free market system.

To determine why Buffett found this a good investment, I looked at many criteria as found in the book Buffettology, written by Buffett's former daughter-in-law, Mary Buffett and the website validea. Given Buffett's new investment in Goldman Sachs, I thought it would be worthwhile to look in detail at the common stock.

GS earns high marks based on my Buffett strategy, earning a score of 79% out of 100%. Let's look at what the Buffett strategy likes about Goldman Sachs to shed some insight into one way Buffett may have looked at this investment. First off, Goldman Sachs is a large global bank holding company that engages in investment banking, securities and investment management. Goldman Sachs was founded in 1868, and is headquartered in the Lower Manhattan area of New York City at 85 Broad Street.[1] Goldman Sachs has offices in most major world financial centers.

The firm acts as a financial advisor and money manager for corporations, governments, and wealthy families around the world. Goldman offers its clients mergers & acquisitions advice, underwriting services, asset management, and engages in proprietary trading, and private equity deals. It is a primary dealer in the U.S. Treasury securities market.In short, it has a "big moat", a Buffett criteria.

That's the qualitative side of it. Now let's look at the quantitative side, which is where my Buffett model comes into play. GS has the steady, reliable earnings history that Buffett likes to see. Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Annual earnings per share from earliest to most recent were 5.67, 5.57, 6.00, 4.26, 4.03, 5.87, 8.92, 11.21, 19.69, 24.73. Buffett would consider GS's earnings predictable, although earnings have declined 3 time(s) in the past seven years, with the most recent decline 6 years ago. The dips have totaled 36.2%. GS's long term historical EPS growth rate is 14.4%, based on the 10 year average EPS growth rate.

Consistent profitability is not enough. In addition, Buffett likes to see a high return on equity (ROE). Over the past 10 years, GS has an average annual ROE of 19.3%. That's plenty good for meeting this model's 15% minimum requirement. The ROE for the last 10 years, from earliest to latest, is 37.7%, 24.3%, 17.5%, 11.1%, 10.0%, 12.8%, 17.1%, 17.5%, 22.7%, 22.6%, and the average ROE over the last 3 years is 20.9%, thus passing this criterion. GS's management has proved it can earn shareholders 21.4% return on the earnings they kept. This return is more than acceptable to Buffett. Essentially, management is doing a great job putting the retained earnings to work.

Share buybacks are also important and GS's total shares outstanding have fallen over the last five years, although the half-billion share secondary offering on Thursday will no doubt alter that trend.

So, for the most part, the firm gets high scores on a fundamental basis, but there are two measures where it falls short. One is the Capital expenditures and another is return on assets. Both are likely to improve and Buffett has required key management to hold their shares during the time Buffett remains invested.

After the business analysis is done, he then moves onto the question, "Is the price right?" Consider this: GS's stock is currently at 128, down from a high of 225 a year ago. We know that Buffett wants to invest when others are most "fearful" and at a price that gives him a reasonably good chance at making a profit over the long run.

Buffett gets a great deal with these preferred shares, but I think long-term investors may be presented with a wonderful buying opportunity here in the common shares as well. While this is a favorable piece on GS, it is more about providing you with insight into how to evaluate stocks for your own investment success.