Last year the All Share Index and Market Capitalisation of the Nigerian Stock Exchange (NSE) attained new heights, with NSE achieving over 70% growth, driven mainly by the banking sector. Gains were driven by easy money and the consolidation of the sector, which has had a positive impact on performance.

This drew new players into the market (domestic and overseas entrants) to the point where the equities market now occupies a large share of the public consciousness. Many are buying into banking stocks with the expectation they will deliver similar result to last year’s.
Are they going to enjoy bumper profits or have they arrived too late and are they going to end up disappointed, or worse still in tears?

Here are five signs you should be watching out for:


The sectors’ PE ratio
Theoretically, Price to Earnings (PE) tells us how much investors are willing to pay for a naira of earnings. It also tells us how long we will have to wait before we get our investments back. The conventional view is that when PEs are above the long-term average, stocks are going to fall and when they are below it stocks will rise.

An overvalued stock is often one whose PE ratio is high relative to the rate at which a company's earnings are likely to grow. In some cases, the future performance of these stocks may not be able to sustain the high expectations implicit in the price investors are paying. In a downturn, the price typically falls until the stock's PE comes in line with its historical PE.

In contrast, an undervalued stock is selling at a PE that is modest relative to other stocks in the same sector or industry. Investors who seek out these stocks can reap the benefit of strong future performance. If investors’ attention shifts to their merits and demand for the stock increases a price surge can be created.

Nigerian banks currently trade at an average PE of about 24, higher than at any other time in recent years (historic banking PE has been between 8 and 12.) Of course, there are a number of factors that support the high PE

     Earnings growth is also at record levels. If it is sustained at these levels then the current PE could easily be justified, but if not, then there could be a problem.

   The banks are bigger and (supposedly stronger), so the higher quality could justify a higher PE.

   Interest rates are lower and expected to continue to fall. Lower interest rates usually support higher PEs. However, one would expect this factor to affect all the shares on the Exchange equally.

     Reported inflation has been dropping and is expected to continue to fall over the next few years. Lower inflation also supports higher PE ratios.

For the banking sector’s PE to come down to 15 (closer to historic levels) over the next three years whilst delivering the owners of stocks 15% annual appreciation (plus the current dividend) would take an average earnings growth of 45% per year for 2008 and 2009, a tall order, but not unachievable given banking performance over the last two years.

Of course, if investors are expecting higher returns, say 25% per year (remember that a lot of people are borrowing at 20% to buy shares), then the profit growth required is much higher; over 60% yearly profit growth is required. We don't see this happening, certainly not across the entire banking sector.

So from a PE point of view, we would say that banking stocks are highly valued, in fact, scary highly valued, but probably not significantly overvalued. However, we don't expect investors to get the very high share price appreciations that they enjoyed over the past few years.


Earnings yield
Another way of looking at the pricing of a sector is to compare its earnings yield to the yield of competing investments, particularly bonds.

The sector’s 4.2% earnings yield is low when compared to the 8% yield on treasury bills or compared to 5.7%, which was the earnings yield for the sector in 2001.

Again the bulls explain that the rate of profit growth, higher quality (lower risk) earnings and lower inflationary environment argue for a lower yield.

Going forward, look out for companies that will offer a higher yield than those obtainable from money market instruments to compensate for the risk of owning shares instead of bonds and other asset classes (treasury bills now offer between 8% and 10%, depending on the tenor). Anything below this will be too low for investors based on future earnings outlook for the sector.

High price to book ratio - PB
A low PB could mean that the sector is undervalued while a high ratio could indicate an overvalued sector. The book value also tells us how much we will receive should the company go bankrupt.

The banking sector currently trades at a PB ratio of 5.1x up some 5% over that of 2006, though its trading significantly better than the 7.9x of 2003. We believe that the revenue and profit growth trends and investors’ expectations about future earnings will boost PB ratio and see a decline towards 2006 (4.8x) figure.

To create value, invest in companies with PB ratio below industry average.


High price to earnings growth (PEG) ratio
The PEG ratio is a valuation metric that determines the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected future growth. It compares the PE to the growth ratio of a company. A lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive). A PEG ratio above 1 and that approaches two or goes higher than 2 is an indication of an overvalued stock. Historically, Nigerian banks have traded below 0.6 (2001: 0.3x, 2007: 0.4x). The current PEG of 0.4 indicates that the sector is fairly valued, and that it can deliver 50% earnings growth over 2008.

Return on equity (RoE)
RoE is a useful guide to determine the return that shareholders receive for investing their money with a company. High PB ratios and a falling RoE can indicate a strong performer that may now be overpriced and possibly passing its prime (that is, the shares are still doing well but returns have peaked). Though RoE at 22.5% falls short of 28.1% and 26% achieved in 2001 and 2002, we are impressed with the upward movement, especially when comapred to 18.4% in 2006, implying that RoE are likely to return to their historic levels. This upswing is likely to continue if banks achieve their growth rate projections of over 50%. We expect to see banks achieving a RoE above 25%.

The future growth drivers
Though banks are beginning to play their traditional role (at least in the last 10 to 15 months), we believe a lot of potential still exist in the sector. Factors that will drive growth include:

   Huge infrastructure requirements by the economy, with power, transportation, telecommunications and hydrocarbons being the most pressing ones

  Low retail banking penetration, with mortgages representing only 0.5% of GDP compared to South Africa’s 40%. Also, retail banking services are only 1% of GDP compared to South Africa’s 42%, offering huge potential in our view. ·    An evolving (and new) middle class, which should drive consumer-lending services going forward, with consumer sector gaining more grounds.

   Opportunities for trade finance are present, with Nigeria generating $50 billion in export revenues per annum from oil alone and importing $25 billion of goods per annum.

   Investment banking, with lots of opportunities to tap from.    Growing confidence in the economy and sector

    Increasing FDI funds

   Investments outside the shore of the country.


Concerns
Nigerian banks are positioning themselves to become big players and the capital market appear willing to provide any amount requested. Are the banks going to be able to invest the money in areas that are equally profitable and with similar risk profile as obtainable now, or will there be investment in more risky (or lower yielding) assets?

Another source of concern is lending and underwriting skills and the fact that poor loans tend not to become evident until a few years down the line. If there has been a reduction in lending standards, then we might not see the higher none performing loan ratios until 2009, leading to a rapid erosion of value and shareholder funds.

Corporate governance and banking oversight have never been very high in Nigeria. Though some banks have made visible improvements in their governance, as outsiders we are unable to see if similar changes are being made in terms of attitudes and corporate cultures. We are also concerned as to the amount of capacity building that has been taking place in Central Bank. Even an old and supposedly experienced regulator, The Bank of England, was recently exposed as not having been keeping as close an eye on its banks as it should have been. This led to the nationalisation of Northern Rock, one of the largest UK mortgage lenders.

Conclusion
We believe that there is no crash imminent. However, we also believe that new investors in the banking sector may be sorely disappointed. At the current prices bank stocks have little hope of delivering up to 20% appreciation and no hope of delivering up to 25%. That said, there will still be individual bank stocks that will outperform and deliver higher returns.

Last line: Those who come late to the party cannot expect to eat the same food as those who came on time.