33 Valuation of Shares: Concept, Need & Factors affecting the value of shares

Deepika Gautam

epgp books

 

 

LEARNING OBJECTIVES:

 

After studying this module students may able to reply

 

  •   What is Company?
  •   The concept of Share and its Classes
  •   How equity shares are different from preference shares?
  •    The concept of valuation of shares
  •   Why valuations of Shares are important?
  •    The various factors affecting the value of Shares
  •    Different values of shares

 

WHAT IS COMPANY?

 

A company means a voluntary association of persons united for a common cause. It includes two important facts:

 

(1)   Voluntary Association has large number of members, that it is not to be called a partnership firm,

(2)   Every member of association has a right to transfer his shares without the consent of the other members.

 

Hence, it becomes an incorporated body with perpetual succession and a common seal. It has separate legal entity and it is an artificial person. It is managed by a Board of Directors duly elected by the shareholders. In India, companies are governed by the Indian Companies act, 1956. This law creates it and dissolves it.

 

WHAT IS SHARE?

 

Section 2(46) of the companies act 1956 has defined share as a share in the share capital of the company; and includes stock except where a distinction between stock and share is expressed or implied. Shares must be numbered so that may be identified; they are movable property and can be transferred to any other person in the manner provided by the Article of Association. In fact, a share is an interest of the shareholder in the company, measured in terms of money for the purpose of liability in the first place and of interest in the second place. A share is a right of a company carrying with it certain rights and liabilities. The share capital is the most important requirement of a business. It is the amount which is initially invested by the shareholders and it is divided into a number fixed amount and each small unit are known as shares.

 

Nature of Share: According to section 44 of the 2103 Act, the shares shall be movable property transferable in the manner provided by the Article of the company. Shares of a company are created as goods under Sales of Goods Act, 1930. These can be brought, Sold and Hypothecated.

 

Numbering of Shares: According to section 45 of the 2013 Act, every share of the company having share capital shall be distinguished by its distinctive number. Provided that nothing in this section, shall apply to a share held by a person whose name is entered as holder of beneficial in such share in the records of a depository.

 

(Note: The 2013 Act clarities that the provision regarding distinctive number for each share shall not apply to a share held in De Mat mode.)

 

Types of Shares:

 

According to section 86 of the companies act, a company can issue only two types of shares:

 

(a)    Preference Shares

(b)   Equity Shares

 

(a)    Preference Shares: The law defines preference share capital as that part of the share capital of a company which fulfils both the following conditions namely:

 

(i)      It carries a preferential right in respect of the dividends;

(ii)     It carries preferential right in regard to the repayment of capital

 

The preference shareholders are those who are entitled to receive the fixed rate of dividend out of the net profits of the company. The rate of dividend on preference shares is specified in the articles of association.

 

For instance: 5%Prefernce shares ( It means these share holders are entitled to get 5% rate of dividend, whereas no as such percentage is prefixed with equity shares)

 

After the payment of dividends at fixed rate the balance can be used for declaring a dividend on ordinary shares. Similarly, the assets reaming after payments of the debts of the company are first used for returning the capital contributed by the preference shareholders. But apart from all these privileges there is one limitation of the preference shares and that is it does not carry any voting rights except on those issues which affect their interest such as non-payment of dividends for more than two years.

 

Preference Share Classes:

 

(i)     Cumulative Preference Shares: When the arrears of dividend are cumulative and such arrears are paid before paying any dividend to equity shareholder.

 

(ii)   Non-Cumulative Preference Shares: The dividend is payable only out of the net profits of each year and if there are no profits in any year, the arrears of dividend cannot be claimed in the subsequent years.

 

(iii)   Participating Preference Shares: In addition to preference dividend at a fixed rate, those share are also entitled to participate in the balance of profits with the equity shareholders after they get a fixed rate of dividend on their shares.

 

(iv)  Non-Participating Preference Shares: These share holders are entitled only to get fixed rate of dividend and do not share in the surplus profits.

 

(v)  Convertible Preference Shares: Those shares which can be converted into equity shares within a certain period.

 

(vi)  Non-convertible Preference Shares: Those shares which cannot be converted in to equity shares.

 

(vii) Redeemable Preference Shares: A company limited by shares, may if so authorized by its articles issue preference shares which are redeemable as per the provisions laid down in section 80 after fixed period of time

 

(viii) Guaranteed Preference Shares: These shares carry the right of a fixed dividend even if the company makes profit or not or insufficient funds.

 

(b)   Equity Shares: The shares which are not preference shares are Equity shares. These shares do not enjoy any preferential rights. They rank after the preference shares for the purpose of dividend payment and repayment of capital. The rate of dividend is also generally not fixed and may vary from year depending upon the profits of the company. This rate of dividend is recommended by the directors of the company but they are the real owners of the company as they have voting rights in the management of the company.

 

HOW EQUITY SHARES AND PREFERENCE SHARES ARE DIFFERENT?

WHAT IS VALUATION OF SHARES?

 

The capital of a company is divided into number of equal parts. Each part is called share. Each share has fixed face value. Shares are shown in the company’s balance sheet at their face value not on market value. Thus, it is necessary to calculate the value of a company’s share on a particular date and the process to find out or calculate the value of share is called valuation of shares. In other words, valuation of shares means find out that price which is used for purchase and sale of transfer or tax assessment of shares or for any payment in the form of shares. If provides correct information and states about the position of share capital (The amount invested in the form of shares) to the shareholders and various other interested parties. It should be remembered that as per section 2(84) of Indian Companies Act, 2103 Share means a share in the share capital of a company and includes stock.

 

DIFFERENT AUTHORS VIEW

“A company formed and registered under this act or an existing company”

 

-Section (3) (1) (i) of the Companies Act 1956

 

“A company is an artificial person created by law, having separate entity with a perpetual succession and common seal”

 

Prof. Haney

 

“The interest of a shareholder in a company measured by a sum of money for the purpose of liability in the first place, and of interest in the second, but also consisting a series of mutual covenants entered into by all the shareholders interest”

 

Farewell. J.

 

“The valuation of shares is not an exact science and cannot be reduced to rigid rules or formulate….The

 

valuation of two persons hardly agrees and there is wide divergence in the valuation made by different valuers and the tax authorities. However, due to conventions and judicial decisions over a long time, certain principles have been evolved, on which we can base our judgment”.

 

B. S. Kothari, C.A

 

“The underlying principles of valuation of shares are by no means difficult but their application calls for a considerable knowledge of technical points”.

 

William Pickles

 

Division of Shares from valuation point of view:

 

From valuation point of view, shares may be classified in to two parts

 

(a)    Listed Shares or Quoted Shares

(b)   Unlisted Shares or Unquoted Shares

 

In most cases, shares are quoted on the stock exchange and for ordinary transaction in shares, the price prevailing on the stock exchange may be taken as the proper value. The stock exchange price does not hold good in each case. Although in some cases the stock exchange price may reflect the proper value, but in many cases they do not reflect the true value of shares since the stock exchange quotations are subject to bullish and bearish phases, when the same share is quoted at considerably different prices. Stock exchange quotation are not related directly to a value of the company’s assets or to the quantum of its profits and consequently these quotations cannot form a fair and equitable basis for valuation of shares. Hence, the valuation of shares has to be done by an expert valuer by adopting sound and reasonable basis. In addition to, all shares are not quoted on the stock exchange. Shares of private companies in any case will not be quoted. If, therefore, shares of such company are to be sold or pledged, the value of such shares will have to be calculated.

 

NEED OR PURPOSE OF VALUATION OF SHARES

    Under the following circumstances the valuation of a share is important

 

1.      On Amalgamation at the time of purchase: When two or more companies doing similar business go into liquidation and new company is formed to take over their business, it is known as amalgamation. In such a case, purchase consideration (The purchase consideration is the price which is paid by the transferee company to the shareholders of the transferor company) may be paid in the form of shares and it is agreed that purchase consideration will be calculated on the basis of the intrinsic value of share of the transferor company and the Intrinsic value of share can be calculated by dividing the net assets by the number of shares of the paid up capital of the company and for that valuation of shares is necessary.

 

2.      On the internal reconstruction of the company: Under internal reconstruction a company continues in its legal entity forma and is only recognized internally under section 319 of the 2013 Act. The objective of internal reconstruction is to reduce the value of shares to their actual value i.e., to reduce the share capital to the extent to which there is deficiency in the value of assets. Therefore, in such a case to determine the amount payable to dissentient shareholder valuation of a share is important.

 

3.      On conversion of shares: Where share of one class to be converted into shares of another class, for example conversion of preference shares to equity shares. Here also point to be noted is that only convertible preference shares can be converted in to equity shares.

 

4.      Shares of private companies: Generally shares of private companies are not quoted on the stock exchanges and if shares of such company are to be purchased or sold, the value of such shares will have to be calculated so here also valuation required..

 

5.      Appraisal of the Shares: When the shares are not quoted in stock exchange, the value of such shares has to be ascertained.

 

6.      For taking loan on shares security: Where loans are raised on the security of shares of a company, it is necessary to ascertain the value of shares.

 

7.      For the valuation of the Assets: The valuations of shares are made by companies to find the correct value of his assets for declaring the net asset value. (When amount for the asset is paid in the form of shares).

 

8.      For determination of gift tax: When shares are received as a gift, it may be necessary to place a value on the shares for the purpose of assessing gift duty payable by the receiver.

 

9.      Nationalization of companies: When government wants to compensate the shareholders on the nationalization of a company, in such a case it is important to value the share.

 

 

FACTORS AFFECTING THE VALUE OF SHARES:

 

The factors that affect the value of shares of a company are similar to those that affect the value of goodwill of the company as both are interlinked because goodwill is the reputation of the company. The principle factors affecting the valuation of the shares are:

 

 

1.      Earning capacity of the company: The following facts are considered in this regard:

 

(a)    Average profits earned in the past, (Average Profit can be calculated by dividing total profits by the number of years)

   (b)   The lowest and highest profits earned in the past,

 

(c)    The average rate of return on capital employed;

 

(d)   Profits remaining after paying tax and dividend to preference shareholders,

 

(e)    Recent events and those likely to occur which will affect the profits

 

2.      Efficient management: The companies which have good management and progressive life generally command good value of shares n the market.

 

3.      Rate of return in the same type of industry: The value of a share will much depend on the dividend yield that the investor expects to get as compared to the normal rate of prevailing in the market in the same industry.

 

4.      Accounting ratios: A company with sound accounting ratios like current ratio, liquid ratio, inventory turnover ratio, debtors turnover ratio, creditors turnover ratios, net profit ratio etc. is favored by the investors and have the high value of its shares.

 

5.      Government policy: The government offers special incentives for particular type of business. E.g., tax concessions for companies in backward areas and if a company enjoy such concessions, the value of such shares will increase.

 

6.      Fully paid up or partly paid up shares: Investors take a negative view of the partly paid shares which may reduce the value of shares in the market

 

7.      Demand and supply of shares of the company: If shares of a particular company are demanded high then it automatically lead to increase in its value.

 

8.      Dividend policy: Dividend is the part of the profit which is distributed among the shareholders. Preference shareholders are entitled to get fixed rate of dividend whereas equity share holder will get the dividend only when company earns profit. If company follows stable dividend policy then it fetch high rate of its shares and vice versa.

 

9.      Net tangible assets of the company: Those assets which can be seen touched and move from one place to another.

 

10.  Others:

 

a)      Nature of a business.

 

b)      Future prospects of the industry in which a company is engaged

 

c)      Capital structure of the company.

 

d)      Number of share holders

 

e)      Extent of competition

 

f)       Extent of government control on company

 

g)      Position of a peace and security in the company

 

h)      Political conditions such as fear of nationalization etc.

 

 

DIFFERENT VALUES OF SHARES:

 

A difficulty arises regarding the valuation of shares, as shares have a different value which can be explained in following manner:

 

1.      Face Value: A company may divide its capital into shares of different denominations like Rs1, 2, 5, 10 and 100 or any other suitable amount. For example, the total capital of the company is Rs 20,00,000 divided in to 2,00,000 shares of Rs 20 each. This face value must be printed on share certificate. Company’s share capital is known as per the face value of share. Share may be issued at less or more price of face value. It is also known as par value. In simple words shares can be issued at par, more than par or less than par. E.g. Share having face value 10 can be issued at 10, 8 or even at 12.

 

2.      Book Value: The full value of shares does not represent the true worth of share of acompany. Book value can be calculated as: Reserves and accumulated profits are added to share capital of company and accumulated losses is to be deducted from share capital and the remainder represents book value. This figure then will be divided by the number of shares and the result will be book value of the share.

 

3.      Cost Value: Cost value refers to those prices on which the shares are purchased from the others. It also includes the purchase expenses or the cost incurred while purchasing the share such as brokerage, commission etc.

 

4.      Market value: Market value refers to those prices on which the shares are purchased or sold in the market. This value may be more or less or equal than that of face value. It is important for the companies to publish the value of share in the leading newspaper daily media put on the websites of stock exchanges and communicated in electronic.

 

5.      Capitalized Value: The average profits of the company are capitalized at normal rate of return; this is called capitalized value. In order to find out the capitalized value of each share of a company this capitalized amount is divided by a number of shares of the company

 

 

NOTE: SOME IMPORTANT TERMINOLOGIES

 

1.      Company: A voluntary association of persons joining hands together for the common goal.

 

2.      Share: A small part of the capital

 

3.      Capital: Amount invested by the shareholder.

 

4.      Dividend: A part of the profit which is distributed among shareholders.

 

5.      Shareholder: The holder of share or a person who possesses shares.

 

6.      Consideration: The price which is paid by the transferor company to transferee company.

 

SUMMARY

 

The capital of the company is divided into number of equal parts and each part is called share. There are two types of shares equity and preference shares and the holder of share are called shareholder. Each share has its fixed face value and shares in the company’s balance sheet are shown at their face value not the market value. Thus, it is necessary to calculate the value of a company’s share on a particular date and this process is called valuation of shares. There are number of circumstances arise in a company when valuation of share is important say it at the time of amalgamation, On the reconstruction, when shares have to be converted and even when appraisal of the shares being done by the shareholder., But there are number of factors which affect the value of share which need to be considered while valuation. In this module we have also studied that shares have a different value so in order to depict the real value of share all these aspects have to be considered.

you can view video on Valuation of Shares: Concept, Need & Factors affecting the value 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  A Company is an artificial person created by law, having separate legal entity.
  • Ø   The share is proportionate part of the share capital and forms ownership in a company.
  • Ø   Each share has fixed face value.
  • Ø The face value must be printed on share certificate.
  • Ø Shares are shown in the company’s balance sheet on a particular date.
  • Ø Share may be of two types: Equity and Preference share
  • Ø Shares are quoted on the stock exchange may be taken as the proper value.
  • Ø The valuation of shares has to be done by an expert valuer by adopting sound and reasonable basis.
  • Ø The valuation of shares is not an exact science and cannot be reduced to rigid rules.
  • Ø Market value refers to the price on which the share are purchased or sold.
  • Ø Earning capacity of the company affect the value of the share.