Book value

Why Nigerian Bank Shares Have a Cheaper Book Value

Addicts to the basics of fundamental investing always remember one of the first stock-picking strategies that Warren Buffet once adopted. He picked stocks that were trading at a discount to their book value.

The idea is simply based on the fact that the market was valuing these stocks cheap since their market value was much lower than their book value or net worth. It actually reminds me of Nigerian banks most of which are notoriously synonymous with stock market valuations that are at a huge discount to their book values.

According to Nairametrics estimates, Nigerian banks are currently trading at a 56% discount to their book value, one of the lowest of any sector on the Nigerian Stock Exchange. FCMB, Fidelity, Sterling Bank and Access Bank rank among the most discounted stocks trading at 28%, 25.1%, 32.1% and 33.2% respectively. So does this mean that Nigerian banks are grossly undervalued? Not so fast.

Stock pickers have realized over the years how wrong it can be to value companies simply based on their discount to book value. The conventional wisdom being that stocks trading at a discount to book value may perhaps be a sign that companies are underperforming or carrying a trailer load of dead assets that they can profitably transpire. . Warren Buffet sums this up quite brilliantly.

“In fact, if anything, we’re less likely to look at something that’s selling at a low to-book ratio than something that’s selling at a high-to-book ratio, because chances are we’ll have deal with a bad company in the first case and a good deal in the second case.

Simply put, a company that fails to deliver a significantly higher return on equity cannot be awarded a higher valuation than a company that delivers a higher return on investment to its shareholders. It is therefore not about the profit declared by a company, but about its efficiency in generating profits. Again, Warren Buffet explains it, referring to a Japanese stock.

“Earnings are what determine value, not book value. Book value is not a factor that we consider. Future earnings are a factor we consider. And as we mentioned earlier this morning, earnings have been lackluster for a lot of Japanese companies. Now, if you think the return on equity of Japanese companies is going to increase dramatically…and you’re right, you’re going to make a lot of money with Japanese stocks…if a company earns 5% of its value I don’t want to buy it at book value if I think it’s going to continue to earn 5% of its book value. A low price-to-book ratio therefore means nothing to us. This does not intrigue us. »

This view may explain why Nigerian banks continue to be valued at a discount to their net assets. Take for example Nigerian banks and their return on average equity. In 2021, a year when we recorded record profits of a total of N889.2 billion for 9 of the largest Nigerian banks, they also recorded a combined return on average equity of 16.3%. Apart from Access Bank, GTB and Zenith, all the banks on our radar posted an average return on equity of less than 18%. It’s getting worse.

The dividend is another important measure of shareholder returns, especially for companies that are mature and have less room for exponential growth. Nigerian banks paid out 35% of their 2021 profits as dividends, offering a dividend yield of 9.5%. Nigerian banks have also maintained a low dividend payout ratio for years, citing the need to comply with the capital adequacy ratio and Basel II requirements. Nevertheless, this strategy now looks like a burden on banks, as they now have to hold more capital without offering a higher return on equity.

Bank stocks also trade daily at very high volumes, making them very liquid and easy to buy and sell for anyone who owns them. With billions of stocks traded daily, the forces of demand and supply make it difficult for their stock price to sustain a long-term rally, even if the fundamentals support the momentum.

Therefore, Nigerian banks, more than any other industry, need to encourage local participation in the stock market, not just through one or more cyclical bulls, but through a concerted effort to foster the habit of investing in stocks among investors. Retail. They will also have to avoid some of the old manipulative stock market practices that have deterred millions of investors after they lost their money investing in Nigerian stocks.