34 Methods of Valuation of Shares

Deepika Gautam

LEARNING OBJECTIVES:

In this module students may learn, what are the various methods of valuation of shares like Net Assets method, Yield method, Capitalization and Fair value method? An attempt has been made to clear the concept of the applicability of different methods in different situations and how company, shareholders, stakeholders and all those who are interested can easily calculate their true value of shares.

METHODS OF VALUATION:

There are different methods of valuing shares which are broadly classified as follows:

A. Net Assets Basis or Intrinsic Value or Breakup Value Method

B. Earning capacity or Yield or Market Value Method

C. Dual or Fair Value Method

D. Return on Capital Employed Method

E. Price-Earnings Ratio Method

(Generally first three methods are apply)

Let’s discuss each one in detail:

A. Net Assets Basis or Intrinsic Value or Breakup value Method: This method is concerned with the assets backing per share and may be based either:

(i) Case one can be when the company is a going concern,

(ii) Case two can be when the company is being liquidated.

Case one: when the company is a going concern: Under this there are further different approaches which are as follows:

(i) To value the share on the net tangible assets basis by excluding the amount of goodwill

(ii) To value the share on the net tangible assets basis by including the amount of goodwill

(iii) Assets backing where company is being liquidated.

(i) To value the share on the net tangible assets basis by excluding the amount of goodwill

Under this method, it is necessary to estimate net tangible assets of the company and the value of Net Tangible Assets can be calculated by deducting Assets from Liabilities in order to value the shares. While calculating the value of share by this method, care must be exercised to ensure that the figures representing the assets are sound, i.e., intangible assets and preliminary expenses are eliminated and all liabilities (whether in books or not) are deducted from the value of the tangible assets. Non trading assets are also included in the assets and the assets are taken at their market value, i.e., replacement value.

Where both types of shares are issued by a company, the shares would be valued as under:

1. If preference share have priority to capital and dividend, then the preference shares are to be valued at par.

2. After the preference shareholders are paid and the net tangible assets are to be divided by the number of equity shares to calculate the value of each share. If at the time of valuation there is an uncalled capital (the capital which is not yet called by the company), then the uncalled equity share capital be added with the net tangible assets in order to value the shares fully paid up. The valuation of shares for the shareholders who have calls on arrears (When any shareholder fails to pay the amount due on calls) will be valued as a percentage on their paid up value with the nominal value of shares.

3. If the company has equity share of different face value, the total replacement value of assets after deducting the paid up value of preference shares is first apportioned to different categories of equity shares on the basis of paid up value of such categories. The amount so come would be divided by the number of shares in each of such categories to get the value of each share of such categories.

4. If the preference shares are participating and rank equally with the equity shares, then the value per share would be in proportion to the paid up value of preference shares and equity shares.

(ii) To value the share on the net tangible assets basis by excluding the amount of goodwill In many cases goodwill may be worth the figure at which it is stated in the balance sheet or if there is no book value for goodwill, it may nevertheless exist. (Goodwill is the good reputation of the company) Further even if there is a book value, the actual value of goodwill may be considerably higher than the book value. It is generally considered that the value of fixed assets of the company depends upon their ability to earn profits i.e., on the goodwill attaching to them. In such a case, goodwill should be included with other tangible assets for calculating the value of shares.

(iii) Assets backing where company is being liquidated: Assets backing method is appropriate if liquidation is contemplated though realizable value should be taken into account. When realization is imminent it is desirable to construct statement of affairs supported by independent valuation of the fixed assets such as Freehold property, Plant and machinery, Goodwill etc. Provision should also be made for the cost of liquidation and thus some indication may be obtained as to how much per share may be payable to right holders.

Net assets basis of valuation of shares is generally recommended by only those companies where no realistic idea of the earning capacity is possible because of fluctuations in profits and where a large block of shares is to be transferred or when the company is at the stage of winding up. Net assets basis of valuation of shares is also suitable for a company which has been trading at a loss in the past and there are no prospects of earning any profit in the near future. The method of valuation is acceptable for statutory valuation particularly the wealth tax rules provide for assets basis of valuation of shares. Valuation of share by net assets basis is not desirable for a growing company.

And the major practical difficulty in Net assets basis of valuation of shares method is the estimation of market value of assets as there is a lot of subjectivity in ascertaining the realizable value of assets which may not give true or fair value of shares.

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 Current and Fixed assets;

(b) Calculate the value of goodwill by applying any method (as per the information);

(d) All fictitious assets, (Preliminary Expenses, Discount on issue of Shares/Debentures, Debit-Balance of P&L A/c etc.) must not be included;

(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.

Applicability of the Intrinsic Value Method:

(i) For the permanent investors to determine the value of shares at the time of purchasing the shares of any company;

(ii) When the shares are valued at the time of Amalgamation, Absorption and Liquidation of companies;

(iii) When shares are acquired for control motives the also this method can be apply.

Intrinsic worth

(i) It is one of the simplest and logical methods for calculating the true value of shares.

(ii) It is one of the methods which are mostly used by taxation authorities.

(iii) In this method of valuation of shares the present value of goodwill is also considered

(iv) This is useful for company going liquidation as the net realizable value of assets is taken into considerations.

Intrinsic Limitations:

(i) For growing company this method is not suitable.

(ii) As goodwill is taken into consideration, it is difficult to calculate the value of goodwill as there are number of methods to calculate the goodwill.

(iii) This method leads to personal bias as the market price of the asset is to be quoted which is very difficult to ascertain.

(iv) As this method of valuation of share includes the intangible asset such as goodwill, trade market it is not a reliable one.

Example: Calculate the value of share on the basis of the following information.

Issued and Paid up Capital:
6% Preference Shares of Rs 100 each	5,00,000
Equity Shares of Rs 10 each	3,00,000
Total	8,00,000

Average net profits earned by the company are Rs 57,000. Expected normal yield is 7% in case of such Equity Shares. Total Tangible Assets (excluding the amount of Goodwill) are Rs 9,49,000 and total outside liabilities are Rs 95,000.

Goodwill is to be calculated at 5 years’ purchase of the super profits, if any.

Note: Ignore Income Tax.

Solution:

B. Earning capacity or Yield or Market Value Method

There are two ways to compute the value of share under this method of valuation, whicha re as follows:

1. When valuation is based on rate of return

2. When valuation is based on productivity factor

1. When valuation is based on rate of return: The term rate of return here means a return earned by the shareholders on his investments. The rate of return can further be classified as:

(a) Rate of dividend

(b) Rate of earning

(a) Rate of Dividend: This method of valuation of shares is suitable for small blocks of shares because financially weak shareholders are usually interested in dividends as their only source of income is dividend (The term dividend means the part of the profit which is distributed among shareholders). The value of share according to this method is ascertained as follows:

Value of Share=

Possible Rate of Dividend /Normal Rate of Dividend * Paid up value of share

(b) Rate of earnings: This method of valuation of shares is particularly suitable in case of big investors because they are more interested in company’s earning. They are not interested in what the company distributes in the form of dividends. The value of share according to this method is ascertained as follows:

Value of Share = Possible Earning Rate/Normal Earning Rate* Paid up value of shares

Rate of return basis of valuation of share is the method which is to be used in all but exceptional cases. Under this method, the valuation depends upon the comparison of the company’s earning capacity and the normal rate of profits or dividends that is current on outside investment. To ascertain the value of share based on profits earning capacity, future maintainable profits and normal rate of profits or dividends at which the profits are to be capitalized must be fixed. In arriving at the profit to show the normal earning capacity generally the following adjustments are made:

(i) Non-recurring item should be allowed for.
(ii) Income tax charges should be appropriated to the particular years in which they are paid.
(iii) Allocation to reserve

The main purpose of adjustment of profit is the determination of future annual maintainable profit which can be used for distribution as dividend. The rate of interest for capitalizing the average normal profit is fixed upon by the circumstances of a particular case. Generally @ of 10% or more may be reasonable.

The following steps may be followed for calculating the value of shares according to yield method:

2. Valuation based on productivity factor: Productivity factor means the earning power of the company in relation to the net worth of the company. It is calculated as follows:

Productivity Factor= Average Weighted Taxed Profit/Average Weighted Net Worth*100

Average Profit and Average Net Worth are ascertained by taking a number of years whose results are relevant to the future.

Productivity factor (as calculated above) is applied to the net worth of the company on the valuation date of shares to arrive at the maintainable profits of the company. The projected earnings after necessary adjustments (if any) such as dividend on preference shares, effect of under-utilization of productive capacity, making appropriation for rehabilitation and replacement purposes, are dividend by the normal rate of return to arrive at the value of the company’s business in relation to the equity shareholders. The value of company’s business so obtained is dividend by the number of equity shareholders to get the value of each equity share.

Earning Capacity Worth:

(i) This method is most reasonably accepted being this method is based upon comparison expected rate of return with normal rate of return.

(ii) This method is useful in case of minority holdings since they are interested in the profits earned by the company.

(iii) It is best suited to a company which is a going concern.

Earning Capacity Limitations:

(i) Difficulties may arise while selecting the normal rate of return.

(ii) The values of net assets of the company are totally ignored.

(iii) It is not suitable for the company which is going into losses for the past few years.

(iv) The method contains various difficulties while application of this method.

(v) Predicting the future maintainable profits is difficult to ascertain.

Example: From the following information, calculate the value of an equity share:

(i) The paid up share capital of accompany consists of 1,000 15% preference of Rs 100 each and 20,000 equity shares of Rs 10 each.

(ii) The average annual profits of the company after providing for depreciation and taxation amounted to Rs 75,000. It is considered necessary to transfer Rs 10,000 to General reserve before declaring any dividend.

(iii) The normal return expected by investors on equity shares from the type of business carried on by the company is 10%.

Solution:

C. Dual or Fair Value Method:

Many accountants are of the view that neither the net assets basis nor the earning basis of valuation of shares is correct, but the fair valuation method may be an average of the two methods of valuation of shares. The formula for the valuation of shares according to the dual method or fair value method is as follows:

Value of Share= Value of share on net assets basis+ Value of a share on earning basis 2

Since this method takes the average of the values obtained in net assets basis and earnings basis, it makes attempt to minimize the demerits of both net assets basis and earnings basis methods.

Example: Calculate the fair value of the share of the company from the following information:

1. Net Assets available to equity Shareholders 2,82,500

2. 2,000 Equity Shares of Rs 100 each.

3. The normal rate of dividend, declared by such type of companies is 15%.

4. The average rate of dividend, declared and paid by this company is 18% on its paid up capital.

Solution:

Value of Equity Shares according to yield method

Value of Share = Rate of Dividend/Normal Rate of Dividend*Paid up value of Share

Value of Share = 18&/15% *100= Rs 120…………………………………… (I)

Value of Share on the basis of Net Intrinsic Value

Value of Share = Net Assets Available to Equity Shareholder/No of Equity Shares

Number of Equity Shares = 2000

Value of Share = 2,82,500 /2000

Value of Share = Rs 141.25……………………………………………………. (II)

Fair Value of Equity Share

Value on the basis of Yield + Value on the basis of Net Assets

Value of Share = Rs 120 + 141.25

Value of Share = Rs 130.63

D. Return on Capital Employed Method:

Under this method, valuation of share is made on the basis of rate of a return to be considered 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 these expected earnings, we are to determine the capital sum for such a return.

Following steps should be followed to compute the value of share:

(a) Ascertain the maintainable expected profits after all adjustments, if any;

(b) Ascertain the normal rate of return on capital employed for a similar business;

E. Price-Earnings Ratio Method:

This is the ratio which relates the market price of the share to earning per equity share.

It is calculated as:

Price – Earnings Ratio (PE Ratio) = Market Price of a Share (MPS)/Earning Per Share

SUMMARY

Net assets basis of valuation of shares is generally recommended by those companies where no realistic idea of the earning capacity is possible because of fluctuations in profits and this method of valuation of shares is also suitable for a company which has been trading at a loss in the past and there are no prospects of earning any profit in the near future. This method of valuation of shares is suitable for financially weak shareholders who are usually interested in dividends. It is best suited to a company which is a going concern. Since fair value method takes the average of the values obtained in net assets basis and earnings basis, it makes attempt to minimize the demerits of both net assets basis and earnings basis methods.

you can view video on Methods of Valuation of Shares

Few Suggested readings to learn more:

Gupta R.L & Gupta K.V (2005) “Principles and Practice of Accountancy” Sultan Chand & Sons 23, Daryaganj, New Delhi- 110002.
Jain P.K (2006) “Corporate Accounting” Kalyani Publishers, Old Maujpur, Shahdara, Delhi-53.
Juneja Mohan .C & Singh Baljindar (2008) “Accountancy- I” Kalyani Publishers, B-15, Sector 8 Noida
Mukherjee A & Hanif M (2003) “Financial Accounting”. Tata Mc Graw Hill Education Private Limited NewDelhi.
Singh Baljinder & Mahajan R.K (2014), “Accountancy-I”. New Delhi- 110 002: Kalyani Publishers
Singla.R.S (2015), “Corporate Accounting”. VK Global Publications Pvt. Ltd. New Delhi
Siddiqui A.S”(2002) “Comprehensive Financial Accounting” Laxmi Publications Ltd, 22, Golden House, Daryaganj, New Delhi.
Tulsian . P.C (2014) “Financial Accounting”. Dorling Kindersley Pvt Ltd., licenses of Pearson Education in South Asia.

Points to Ponder

Ø Net assets basis of valuation of shares is generally recommended by those companies where no realistic idea of the earning capacity is possible.
Ø Net Tangible Assets can be calculated by deducting Assets from Liabilities in order to value the shares.
Ø This method of valuation of shares is also suitable for a company which has been trading at a loss in the past and there are no prospects of earning any profit in the near future.

Ø This method of valuation of shares is suitable for financially weak shareholders who are usually interested in dividends.
Ø It is best suited to a company which is a going concern.
Ø The term rate of return here means a return earned by the shareholders on his investments. The rate of return can further be classified as: Rate of dividend Rate of earning
Ø Fair value method takes the average of the values obtained in net assets basis and earnings basis, it makes attempt to minimize the demerits of both net assets basis and earnings basis methods.
Ø The main purpose of adjustment of profit is the determination of future annual maintainable profit which can be used for distribution as dividend. The rate of interest for capitalizing the average normal profit is fixed upon by the circumstances of a particular case. Generally @ of 10% or more may be reasonable.