Why Nigerian bank stocks' profitability ratios are lower

Fanatics to the fundamentals of investing often recall one of Warren Buffet's initial stock-picking tactics. He chose stocks that were trading at a lower price than their book value.

The concept is simple: the market was undervaluing these stocks since their market value was significantly lower than their book value or net assets. This reminds me of Nigerian banks, which are infamous for having market valuations that are significantly lower than their book values.

Nigerian banks are currently trading at a 56 percent discount to their book value, according to Nairametrics, one of the lowest discounts of any sector on the Nigerian Stock Exchange. FCMB, Fidelity, Sterling Bank, and Access Bank are among the most heavily discounted stocks, with discounts of 28 percent, 25.1 percent, 32.1 percent, and 33.2 percent. So, does this imply that Nigerian banks are undervalued? Not too quickly.

Over time, stock pickers have realized how wrong it can be to value companies only on the basis of their discount to book value. Stocks that trade at a discount to book value are thought to be underperforming or carrying a trailer load of dead assets that might be sweated successfully, according to conventional opinion. Warren Buffet perfectly conveys this.

"In reality, we're less likely to look at something that sells at a low connection to the book than something that sells at a high relationship to book because we're more likely to be looking at a bad business in the first case and a successful business in the second."

Simply said, a company that fails to generate a considerably greater return on equity when compared to one that provides superior returns on investments to its shareholders cannot be valued at a premium. It is thus not about a company's proclaimed profit, but about how effective it is in delivering profits. Warren Buffet explains it once more, this time using a Japanese stock as an example.

"Earnings, not book value, determine value." We don't take book value into account. We take into account future earnings. And, as we indicated earlier this morning, many Japanese corporations have had dismal profits. Now, if you believe that the return on equity of Japanese companies would rise dramatically...and you're right...you'll make a lot of money in Japanese equities... If a firm earns 5% on book value, I don't want to buy it at book value if I believe it will continue to earn 5% on book value. As a result, a low price-to-book ratio has no meaning for us. It does not pique our interest."

This viewpoint may explain why Nigerian banks are still valued at a lower level than their net assets. Consider Nigerian banks and their average return on equity. In 2021, nine of Nigeria's most important banks recorded a combined 16.3 percent return on average equity, a year in which they generated record profits of N889.2 billion. All of the banks on our radar, with the exception of Access Bank, GTB, and Zenith, had a return on average equity of less than 18 percent. Things are just going to get worse.

Dividends are another significant indicator of shareholder returns, particularly for mature companies with little capacity for exponential growth. Nigerian banks paid out 35 percent of their income in dividends in 2021, yielding a 9.5 percent dividend return. For years, Nigerian banks have kept their dividend payment ratio low, claiming the necessity to meet capital adequacy and Basel II criteria. Nonetheless, this strategy is beginning to appear to be a strain for banks, since they must now maintain more capital while also generating a better return on equity.

Bank shares also trade in enormous volumes on a regular basis, making them incredibly liquid and easy to purchase and sell for anyone with access to them. The forces of demand and supply make it difficult for their share price to sustain a rally in the long run, even if the fundamentals support the momentum. With billions of shares traded daily, the forces of demand and supply make it difficult for their share price to sustain a rally in the long run, even if the fundamentals support the momentum.

As a result, Nigerian banks, more than any other industry, must work hard to encourage local involvement in the stock market, not just during cyclical bull markets, but through a determined effort to instill a habit of investing in stocks among retail investors. They'll also have to avoid some of the traditional stock market manipulation tactics that scared away millions of investors after they lost money on Nigerian equities.