A couple of weeks ago, Goldman Sachs reported its most recent quarterly financial performance. In short, the company did great. It smashed expectations for both revenue and earnings. In the beaten down world of financial services, this kind of news is especially good.
It’s one thing to celebrate a good quarter. It’s another thing to know how the revenue and earnings dollars came to be. This is a good time to ask ourselves something: how does Goldman Sachs make money?
Let’s first take a high-level look at the different segments of Goldman’s business. Then we can get an idea of what activities are most responsible for Goldman’s financial performance.
The pieces that make up Golden Sachs
Here’s how Goldman Sachs describes itself, via its most recent 10-K report:
Goldman Sachs is a leading global investment banking, securities and investment management firm that provides a wide range of financial services to a substantial and diversified client base that includes corporations, financial institutions, governments and individuals.
Goldman Sachs reports its financial results across four segments, which gives us an idea of how they think about their own business:
- Investment Banking — giving advice on mergers and acquisitions and helping companies raise capital from investors and creditors
- Institutional Client Services — buying and selling financial products on behalf of clients
- Investing & Lending — lending money to companies, and buying and selling financial products on the behalf of Goldman Sachs
- Investment Management — actively managing investments for individuals and institutions
Breaking down Goldman’s financial performance
Before we look into the specific segments, let’s look at Goldman’s performance all-in. The bar chart below shows Goldman’s reported revenue and earnings for 2013 through 2015. You’ll see for this three year window, Goldman generated about $34 billion annually. Earnings hovered around $12 billion in 2013 and 2014, but fell dramatically to $9 billion in 2015.
As a next step, let’s get a feel for scale. From a revenue perspective, does one of Goldman’s business segments contribute more than the others?
The pie chart below shows how Goldman’s revenue from 2013 through 2015 breaks down across their four segments. We can see that Institutional Client Services makes up nearly half of the total revenue. The other half of revenue is distributed nearly evenly across the remaining three segments: Investment Banking, Investing & Lending, and Investment Management.
Interestingly, if we look at the same pie chart, but for pre-tax earnings, we get a different picture. The largest contributor to pre-tax earnings is Investing & Lending, at 34%. Then we have Institutional Client Services (28%) and Investment Banking (26%). Consistent with the revenue picture, Investment Management is the smallest contributor to pre-tax earnings (12%).
What observations can we make? Keep in mind, we’re only looking at data from 2013 to 2015.
- Investing & Lending is the earnings powerhouse. It contributes a much larger fraction of earnings dollars than revenue dollars.
- Investment Banking is the other segment with above average margins. It also generates a larger fraction of earnings dollars than revenue dollars.
- Institutional Client Services and Investment Management have subpar profitability. They each make up a larger share of revenue dollars than earnings dollars.
- Investment Management makes up the smallest portion of revenue, and an even smaller portion of earnings. It is the least consequential of Goldman’s business segments.
Finally, let’s look at pre-tax earnings margin, i.e. pre-tax earnings divided by revenue. The bar chart below shows this margin for each of business segment of Goldman Sachs, from 2013 through 2015. As expected, Investing & Lending is the most profitable segment, followed by Investment Banking. Institutional Client Services and Investment Management both bring Goldman’s corporate profitability down.
Which segment does Goldman Sachs think is most important?
There’s no way to really know the answer to this. But here’s one anecdote. We can look at Goldman’s 2015 annual report. In their letter to shareholders, the chairman and CEO (Lloyd Blankfein) and the president and COO (Gary Cohn) list the segments in this order:
- Investment Banking
- Institutional Client Services
- Investing & Lending
- Investment Management
Investment Banking doesn’t generate the most revenue, or the most earnings. But it’s a sexy business, no doubt. It’s probably what Goldman is best known for. So it makes sense that senior executives would lead with it.
Next came Institutional Client Services, which generates the most revenue. According to Yahoo! Finance, institutional and mutual fund owners own about 73% of Goldman Sachs. Thus, it makes sense that the annual letter focuses on Goldman’s corporate clients. Their corporate clients are the exact kinds of entities that own a majority of Goldman Sachs itself.
Here’s an interesting excerpt from Goldman’s 2015 letter about the Institutional Client Services segment (excuse their finance speak):
Moving forward, addressing structural changes in our Institutional Client Services businesses, such as risk-based capital rules, will remain a central focus for our management team. At the same time, we will look for ways to advance our franchise in the evolving landscape. Competitor retrenchments in the wake of structural developments should provide an opportunity for us to capture market share over the longer term.
By “structural changes”, Goldman Sachs means increasing financial regulation. With increased regulation comes more constraints on both Goldman Sachs and its clients.
One way to respond? Shrink and avoid the pain. That’s what Goldman claims their competitors are doing. Goldman will respond differently, by embracing new regulations and capturing more share. That’s risky, given that Institutional Client Services was Goldman’s lowest margin business from 2013 through 2015. Relative growth in that business will dilute Goldman’s overall profitability.
Goldman lists its most profitable segment, Investing & Lending, third. This is where the firm invests directly in companies or real estate, and where it makes loans to companies. From what I can tell, Goldman’s leaders like talking about this segment the least. It’s probably the one with the greatest public relations problem.
Since the financial crisis, the public is generally uneasy with banks taking on a lot of risk. Placing bets directly on companies, or in real estate markets, is inherently risky. You can see, though, why Goldman places these bets. They generate good returns. It’s a murky area, from a regulatory perspective. It will be interesting to see how Goldman manages this segment going forward.
Finally, Goldman closes with Investment Management. This is the smallest segment by both revenue and earnings. On top of that, it earns subpar margins. This segment is where Goldman works with everyday folks:
We serve investors of all types, including retirees in need of mutual funds, entrepreneurs who have sold their companies and pension fund managers who need help with asset allocation.
It’s not lucrative, but it helps connect Goldman with the broader public. It’s another way to take advantage of all the financial acumen Goldman builds through its partnerships with corporate clients. It’s a business, even with depressed margins, that executives want to grow:
As we look ahead, this means we see opportunity to grow substantially — both by continuing to gain market share in our incumbent businesses and by expanding into new ones.
How does Goldman Sachs make money?
We’ve run through Goldman’s structure. We’ve seen how its different business segments perform. With this all in mind, how does Goldman Sachs actually make money?
Here are its biggest activities, when you weight by both revenue and earnings, in no particular order:
- Investing directly in companies and real estate
- Advising companies on mergers and acquisitions
- Helping companies sell bonds to investors
- Helping companies make investments in stocks, bonds, currencies, and commodities
Put another way, Goldman Sachs helps its clients achieve their relatively complex financial goals. Anyone can walk into a bank and open a savings account. Goldman is helping the world’s largest corporations execute some of the world’s most complex financial transactions.
Equally importantly, though, Goldman Sachs invests on its own behalf. It gets an inside look at the companies and institutions that shape the global economy. It gets direct access to the most influential executives. This proprietary knowledge helps them hone their investment acumen. They monetize that acumen for the benefit of themselves and their clients.