- Overview of Goldman Sach Company
- Risk Return Trade Off
- Discounted Cash Flow/ EBIT Method of Valuation
- Relative Valuation
- Impact of Risk Return Trade Off on Managerial Decisions
- Impact of Trade-Offs on Decisions of Goldman Sach Company
- Works Cited
The global economic conditions have affected the financial markets to a great deal causing companies to make use of strategies that seek to maximize returns and minimize losses while prudently and effectively managing risks. The level and composition of equity capital held by companies is of great concern as it influences their stability especially in times of fluctuations in currency levels of exchange, market volatility and other inherent risks and uncertainties. However, the operation and risk management of organizations is influenced by regulations such as government policies, exchange securities acts and other market and investment policies. Credit and liquidity levels in the economy are affected by decision making based on risk analysis which at times may lead to crisis. Therefore, to establish normalcy and credibility, management of strategic and financial risks must be integrated and vest ownership based on the levels of the CEO. This paper shall evaluate the risk return trade offs and their impact on managerial decisions with reference to Goldman Sach Company.
Overview of Goldman Sach Company
Goldman Sach Company was founded in 1869 and is “a global investment, securities and banking company, which is specifically involved in; investment management, financial services, securities and investment banking” (Goldman Sach Inc. 1). Goldman offers services such as advising clients on acquisitions and mergers, underwriting services, effective ways of managing assets, prime brokerage with main clients being; governments, individuals, corporations and financial institution (Goldman Sach Inc. 1). Consequently, it is also involved in deals in private equity, proprietary trading and the treasury market for securities.
Blankfein outlines the specific activities in each investment portfolio (1). He argues that investment mainly encompasses strategic provision of corporate services and linking the resources of the firm to the needs of the clients which are usually specific. This process entails involvement in the expansion of the businesses of the clients through advice offered on management of liabilities and assets, improving accessibility of capital markets as well as balance sheet restructuring to solidify the client’s financial strength. Blankfein further points out that investment include assessing and facilitation of clients during the processes of mergers and acquisitions to strategically obtain the best alternative investment, advice concerning activities meant for the corporate defense of clients and use of trade off analysis to engage in divestitures. On the other hand, it entails effectively creating and managing investment funds for clients without excluding advice based on their financial and investment capacities for stability.
The service of effective management of assets as well as securities mainly focuses on financial assets that corporations and non profit organizations have or wish to acquire for holding on long term basis. When it comes to individuals, Goldman uses individualized plans suited for their specific needs. Inclusively, it also involves use of mechanisms such as hedge funds, mutual funds, private and public pension funds which all have a base on prime brokerage. In addition, it is also carries out services of security lending. Blankfein emphasizes that fact that the security services of Goldman include enhancing stable levels of liquidity in main trade areas such as those involving equity, fixed incomes and commodities, derivative products and currencies while facilitating the transactions for its clients (1).
Goldman Sach Inc. states that the philosophy of the company mainly entails that wealth creation depends on ownership based on long term basis of a business that has growth potential (1). Its goals are based on effective use of opportunities through risk management with strategies of buying a business of high quality growth at an attractive valuation which is based on different methods of ascertaining the business’s intrinsic worth. The maintenance of a competitive edge for the last 27 years has mainly been as a result of effective investment objectives which seek to manage risks while achieving maximum returns and investment criteria that encompass strong business franchising, long term prospects that are favorable and effective management.
Although Goldman has been effective, criticisms have been made that it does not follow risk levels taken by its rivals like Morgan Stanley hence its turmoil in 2006 through to 2008 (Buehler, Hulme and Freeman 17). Blankfein argues that the turmoil cannot be blamed on sub prime brokerage but rather on the financial system’s creation of excess liquidity and cheap credit (2). This, he asserts, contributed to massive leverage from risk under pricing with factors in play being: low long term interest rates, subsidized home ownership in the United States and increased foreign capital causing significant shifts in the balance of payments for emerging markets. However, Buehler et al. point out that Goldman exploits risks to the maximum in anticipation of higher returns which is enhanced by the maintenance of a risk culture making it achieve performances superior to its rivals (14).
Risk Return Trade Off
Siegel asserts that risk and uncertainty are the same and that adequate information, knowledge and technical awareness are necessary for effective risk management (81). He further points out that there is a correlation between risk and return and effective risk averse or maximizing of risk opportunities to generate returns depends on the organizational structure and culture. Risk-return trade off refers to the levels of risks a company is willing to take up based on the probabilities of achieving certain levels of returns (Shim and Siegel 175). Companies have to learn to deal with risks through the use of effective risk valuation methods to enable them make effective decisions. The expectations of excess returns on risk, real interest rates, stocks and bonds have been known to experience shifts over time though in predictable ways which persist over time hence there is a probability of taking advantage of the risk return trade off (Campbell and Viceira 1).
In order to take advantage of risk-return trade offs, companies make use of different methods of analysis of portfolio, stocks, market, assets and industry based on the time value of money such as discounted cash flow methods, asset based valuation, relative valuation among other financial analysis models (Shim and Siegel 174). Buehler et al. point out the importance of risk return trade off (16-18). They assert that Goldman Sach Company has been able to make returns due to the culture of risk that it uses which is supported by large funding from partnership leverage, reinforcement of business principles and values, having good oversight for risk, effective organizational processes as well as investment in quantitative risk professionals.
Campbell and Viceira point out that changes in investment opportunities have the effect of altering the risk-return trade off of cash, stocks and bonds across horizons of investment hence creating a term structure for the trade off (21). Buehler et al. argue that it is important that in consideration of risk-return trade off, different methods of analysis are used with more research and use of up-to-date technologies to avert and mitigate the adverse effects of the trade off (17). Following the experience of Goldman Sach Company, Blankfein points out that the concept of risk return trade off has to be evaluated through effective risk management practices that take into consideration the emerging changes in the market and economy as well as makes use of the right values of trade off estimation depending on the type of investment (2).
Discounted Cash Flow/ EBIT Method of Valuation
This method of valuation analysis is used in valuation of assets, companies or projects on the basis of time value of money concepts (Shim and Siegel 175). The future cash flow values are normally established through a discounting process and they form the net present value as their value or prices. The analysis process of computation of the net present values involves inputs of the cash flows and then discounting using discount rate to obtain the outputs in the form of the price (Arumugam 7). The discounting rate gives a reflection of the cash flow risk as the weighted average cost of capital that is appropriate due to considerations of the time value of money and the risk premium.
The discounted present value is calculated by the formula:
DPV= t=0∑ n FV/ (1+i) t
Where: DPV- Discounted present value, t- Time and FV- Future value
The weighted cost of capital as the discounting rate is the rate which the company is expected to pay to its shareholders on average to finance the assets (Shim and Siegel 179).
It is normally calculated as: WACC= (E/D+E)* y + (D/D+E)*d(1-tc) given y= tr + tp* B
Where: y is cost of equity in %, d is expected rate of return before taxes, tp is risk premium rate, tc is corporate tax rate, B is beta coefficient, tr is risk free rate, E is total market value of equity while D is total debt and leases.
WACC inputs: Risk free rate is 4.4%, Cost of debt is 6.7%, Equity risk premium is 5.0%, industry D/E is 3.2%, cost of debt is 5.4%,cost of equity is 12.2%, equity is 96.9%, Debt/ capital is 3.1% and tax rate is 18.9% hence the weighted average cost of capital is 12% which is average for investment. This is lower than the cost of equity meaning that the risk level is higher though returns are consequently higher too. Discounting the cash flows at this rate provides the discounted values.
This method of valuation involves obtaining the value of assets or portfolio through a comparison with the market pricing used for other assets or portfolios of a similar kind. Standardized prices are used in valuation of assets on a relative basis and converted to multiples of earning (Shim and Siegel 23). The main approaches in this respect are: the price earning multiple (PEG), price/ sales ratio, P/EBIT, P/CFO or P/EBITDA (Shim and Siegel 24). The authors suggest that this is a simple way of analysis. For example, the price/earnings ratio of Goldman Sach Company is 5.9 compared to the competitors who have 23.1. This means that Goldman Sach Company stands a better profitability chance than its competitors since the price it has to pay on earnings is lower.
Impact of Risk Return Trade Off on Managerial Decisions
Buehler et al. assert that the trade off of risk return is important to management in enabling it to make investment decisions that make use of the best alternative hence avoiding problems of underinvestment and hedging (7). They further assert that the trade off influences the management in engaging in risk transfer markets for growth. These markets include mortgages where the aim is to focus on securitization and mortgages based on the long term to ensure risk spread. The focus on mechanisms and derivatives have been known to cause risk transfer thus allowing mortgage owners to reduce hazards on their portfolio which indeed influence market expansion and increase demand for mortgage products. Buehler et al. further argue that the risk return trade offs have major influences on transformation of wholesale credit markets, increased insurance contracts, investment in private equity and hedge funds (23).
Campbell and Viceira argue that the use of risk return trade off influences the management to consider the influence of other sectors on its leverage (24). This would include sectors such as the energy sector and other non-financial sectors which have the potential of influencing the market liquidity, currency exchange rates and other risk factors. Buehler et al. argue that the trade offs affect managerial decisions through the embrace of risk transparency measures (24). These, they assert, is through the shift of management from single point forecasting to individual based forecasting. The trade offs reveal market polarities due to reliance on historical data and assumptions not supported by much evidence as well as conflicts in interpretation of investment analysis. This calls for the management to have a probabilistic view of major risks. This can be achieved by having individual risk assessment based on foreign exchange risk, geography, country, industry and demand.
Buehler et al. point out that another influence of risk management lies in the risk diversification strategies within the company such as foreign exchange vertical integration or vetting on a multinational basis for efficiency in factor costs (25). Shim and Siegel argue that the trade offs enable management to outline its risks through categorization based on how well each is known in order to monitor its impact on future performance (274). Buehler et al. state that the concept of trade offs impacts the strategic management decisions by enabling companies to identify risks and their competitive advantage (27). This influences the management in mitigation of risks for which they do not have a competitive advantage and to make use of strategies such as hedging, transfer to long term mortgage contracts while entering into joint partnerships and other toiled arrangements with customers.
Further, the trade offs help companies with differentiated capabilities to make decisions regarding increasing skills in project management for large investments and maintaining informational advantages. Buehler et al. argue that companies that have a competitive advantage in some investments following information from trade offs are able to make strategic decisions regarding which emerging market to take advantage of, for instance, common derivatives, reinsurance, financial derivatives, business process outsourcing, and contingent capital among others with emphasis of natural ownership (28). Buehler et al. further argue that trade off help a company in the reexamination of its risk capacity and potential to acquire more risks by identifying the risks it should take advantage and ownership of and those it should mitigate. Buehler et al. state that the risk return trade offs help in identifying the optimum risk capacity for which management is able to identify its position and know when to deal with critical situations (30). Such situations may include optimum levels of interest and dividend to avoid distress, sustenance levels of cash flow for reliability, protection and growth levels of investments, investor credibility maintenance as ewell as understanding the market investment expectations for remaining strategically flexible in the industry. Shim and Siegel note that it is necessary to have trade offs to enable management increase the dimensions for enterprise risk management (275).
Buehler et al. point out that trade offs impact operational decisions through perspectives based on enterprise risks and application in manufacturing, supply chain designs, inventory policing and business process outsourcing among others (31). They further assert that the trade offs influence commercial decisions especially regarding asset management and trading by breaking down complex risks to simpler forms that allow matching effectively and exposure management. The authors argue that the influence of trade offs is felt in financial decisions of management through measurement of cash flow at risks and principles of value at risk regarding what measures to take depending on natural ownership and level of competitive advantage a firm experiences. In investment decisions, the trade offs help to avoid pitfalls through the adoption of measures such as hedging of product prices, turnkey engineering and the ability to quantify value of investment programs on the basis of unfolding events (Masih and Sanjay 36). It is worth noting that trade offs influence strategies of management towards risk management. They point out that the degree of sensitivity has mostly influenced the risk management procedures to move from committees and lower level management and instead take up ownership at the CEO level.
Impact of Trade-Offs on Decisions of Goldman Sach Company
Goldman Sach Company has experienced the impact of risk return trade offs in its policies and practices through fair valuation of its position in order to master the market (Buehler et al. 2). Risk management strategy used by Goldman of creation of risk committees had them play major roles in monitoring of financial risks, overseeing the distribution and underwriting activities, reviewal of reputational and operational risks and extension of credit. However, the trade offs caused a rethink into this due to the critical nature of the risks involved. This has influenced the management to have the decisions of risk management shifted to the level of the CEO due to the amount of ownership involved (Crouhy, Galai and Mark 387). Blankfein asserts that the trade offs influenced risk exposure decisions with Goldman reducing exposure to home equity loans, commercial and residential real estate loans and leveraged loans among others (2). He further asserts that regarding liquidity and funding, Goldman sought to maintain good financial profile by having a steady level of liquidity and significant funding. In fact liquidity level doubled with the increment of capital ratio to 14.5%.
Buehler et al. state that Goldman made use of trade offs during the crisis of 2007 and 2008 to engage in sub prime brokerage, credit trading and mortgage that enabled it to avoid subsequent losses that affected the rivals (16-17). Siegel suggests that the trade offs have influenced Goldman to support moves for transfer of risk such as exchange trading where there are high trading volumes and price mechanisms and central clearing houses for standardized derivatives (287). This is to increase its liquidity and enhance its transparency levels.
This paper has reviewed the concept of valuation of financial companies in an environment of risk. It has focused on benefits of risk return trade offs with emphasis on the discounted cash flow and relative valuation methods. Further, the influences and impacts of the trade offs on managerial decisions has been discussed. In this discussion, emphasis and reference has been made on the Goldman Sach Company.
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