Valuation of Shares


Valuation of Shares 

A. Asset-Backing Method:

Since the valuation is made on the basis of the assets of the company, it is known as Asset-Basis or Asset- Backing Method. At the same time, the shares are valued on the basis of real internal value of the assets of the company and that is why the method is also termed Intrinsic Value Method or Real Value Basis Method.
This method may be made either:
(i) On a going/continuing concern basis; and
(ii) Break-up value basis.
In the case of former, the utility of the assets is to be considered for the purpose of arriving at the value of the assets, but, in the case of the latter, the realizable value of the assets is to be taken. Under this method, value of the net assets of the company is to be determined first.
Thereafter, the net assets are to be divided by the number of shares in order to rind out the value of each share. At the same time, value of goodwill (at its market value), investment (non-trading assets) are to be added to net assets. Similarly, if there are any preference shares, those are also to be deducted with their arrear dividends from the net assets.
However, this following step should carefully be followed while calculating Net Assets or the Funds Available for Equity Shareholders:
(a) Ascertain the total market value of fixed assets and current assets;
(b) Compute the value of goodwill (as per the required method);
(c) Ascertain the total market value of non-trading assets (like investment) which are to be added;
(d) All fictitious assets (viz, Preliminary Expenses, Discount on issue of Shares/Debentures, Debit-Balance of P&L A/c etc.) must be excluded;
(e) Deduct the total amount of Current Liabilities, Amount of Debentures with arrear interest,” if any, Preference Share Capital with arrear dividend, if any.
(f) The balance left is called the Net Assets or Funds Available for Equity Shareholders.
The following chart will make the above principle clear:
Computation of Net Assets

Alternatively:

Net Assets = Share Capital + Reserves and Surplus Revaluation – Loss on Revaluation

Applicability of the Method:

(i) The permanent investors determine the value of shares under this method at the time of purchasing the shares;
(ii) The method is particularly applicable when the shares are valued at the time of Amalgamation, Absorption and Liquidation of companies; and
(iii) This method is also applicable when shares are acquired for control motives.

B. Yield-Basis Method:

Yield is the effective rate of return on investments which is invested by the investors. It is always expressed in terms of percentage. Since the valuation of shares is made on the basis of Yield, it is called Yield-Basis Method. For example, an investor purchases one share of Rs. 100 (face value and paid-up value) at Rs. 150 from a Stock Exchange on which he receives a return (dividend) @ 20%.
Formula for Yield-Basis Method
Under Yield-Basis method, valuation of shares is made on;
(i) Profit Basis;
(ii) Dividend Basis.

(i) Profit Basis:

Under this method, at first, profit should be ascertained on the basis of past average profit; thereafter, capitalized value of profit is to be determined on the basis of normal rate of return, and, the same (capitalized value of profit) is divided by the number of shares in order to find out the value of each share.
The following procedure may be adopted:
Formula for Share Value Calculation

(ii) Dividend Basis:

Valuation of shares may be made either (a) on the basis of total amount of dividend, or (b) on the basis of percentage or rate of dividend:
Valuation of Shares on Dividend Basis
Whether Profit Basis or Dividend Basis method is followed for ascertaining the value of shares depends on the shares that are held by the respective shareholders. In other words, the shareholders holding minimum number of shares (i.e., minority holding) may determine the value of his shares on dividend basis since he has to satisfy himself having the rate of dividend which is recommended by the Board of Directors, i.e., he has no such power to control the affairs of the company.
On the contrary, the shareholders holding maximum number of shares (i.e., majority holding) has got more controlling rights over the affairs of the company including the recommendation for the rate of divided among others. Under the circumstances, valuation of shares should be made on profit basis. In short, Profit Basis should be followed in the case of Majority Holding, and Dividend Basis should be followed in the case of Minority Holding.
The same principle may be represented in the following form:
Yield-Basis Method
Note:
Yield-Basis Method may also be termed as:
Market Value Method; Profit Basis/Income Basis Method;
Earning Capacity Method etc.
Value of share under yield basis:
Formula of Fair Value Method

D. Return on Capital Employed Method:

Under this method, valuation of share is made on the basis of rate of a return (after tax) on capital employed. Rates of return are taken on the basis of predetermined/expected rates of return which an investor may expect on the investments. After ascertaining this expected earnings, we are to determine the capital sum for such a return.
Thus, we are to follow the following procedure one by one:
(a) Ascertain the expected (maintainable) profit (after adjustments, if any);
(b) Ascertain the normal rate of return on capital employed for a similar business;
(c) At last, on the basis of expected rate of return, capitalize the (maintainable) profit.

E. Price-Earnings Ratio Method:

We know that it is the ratio which relates the market price of the share to earning per equity share.

It is calculated as:
Price-Earnings Ratio

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