Methods of valuing shares

Answer 1

Method of Valuing Shares

The different methods of valuing shares may be broadly classified as follows;

1. Net Asset Method (or Intrinsic Value or Breakup value) Method

2. Earnings Capacity (Yield Basis or Market Value) Method

3. Dual (Fair Value) Method

1. Net Asset Basis

This method is concerned with the asset backing per share and may be based either

(a) On the view that the company is a going concern.

(b) On the fact that the company is being liquidated.

(a) Company as a going concern: - If this view is accepted, there are two approaches;

(i) to value the shares on the net tangible assets basis (excluding the goodwill)

(ii) to value the shares on the net tangible assets plus an amount for goodwill

(i) Net tangible assets basis (excluding the goodwill): - Under this method, it is necessary to estimate net tangible assets of the company (Net tangible Assets = Assets - Liabilities) in order to value the shares. In valuing the figures 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 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 shares have priority as to capital and dividend, then the preference shares are to be valued at par.

(2) After the preference shareholders are paid, the net tangible assets are to the 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, then the uncalled equity share capital is added with the net tangible assets in order to value the shares fully paid up. The valuation of shares for the shareholders which have call on arrears will be valued as a percentage on their paid up value with the nominal value of shares. If the company has equity shares of varying face values, the total replacement value of assets left after deducting the paid up value of preference share is first apportioned to different categories of equity shares on the basis of paid up value of such categories. The amount thus arrived at would be divided by the number of shares in each of such categories to get the value of each share of such categories.

(3) If the preference share 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) Net Assets (including 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. 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 the value of fixed assets of the company depends on 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 valuation purpose.

(b) Assets backing where Company is being liquidated: -Asset backing method is sound if liquidation is contemplated though realizable value should be taken into account. When realization is imminent, it is desirable to construct a statement of affairs, supported by independent valuations of the fixed assets such as land and buildings, plant and goodwill. 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 members.

Net assets basis of valuation of shares is generally recommended for only those companies where no realistic idea of the earning capacity is possible because of highly uneven past profits and when a large block of shares is to be transferred or when the company is in winding up. Valuation on this basis is not desirable for a growing company. This method of valuation 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 is acceptable for statutory valuation particularly the wealth tax rules provide for assets basis of valuation of shares.

2. Earnings Capacity (Yield Basis or Market Value) Method

This method of valuation of shares may do valuation by any of the following three ways;

(a) Valuation based on rate of return

(b) Valuation based on price earning ration

(c) Valuation based on productivity factor

(a) Valuation based on rate of return: - The term 'rate of return' here means a return which a shareholder earns on his investment. The rate of return can further be classified as (i) rate of dividend (ii) rate of earning (iii) price earning ratio.

(i) Valuation based on Rate of dividend: - This method of valuation of shares is suitable for small blocks of shares because small shareholders are usually interested in dividends. The value of a share according to this method is ascertained as follows;

Value of shares = Possible Rate of dividend/Normal Rate of Dividend x Paid-up value of share OR

Dividend (in Rs.) per share/ Normal Rate of Dividend x 100

Possible rate of dividend = Total Profit available for dividend/Total paid-up equity capital x 100

Dividend on equity shares is to be calculated by deduction taxation, transfer to reserve, transfer to debenture redemption fund and preference dividend from the maintainable profits and dividing the residual by the number of shares.

(ii) Valuation based rate of earning ration: -This method of valuation of shares is particularly suitable in case of big investors because they are more interested in company's earnings rather than what the company distributes in the form of dividends. The value of a share will be determined as given below;

Value of share = Possible Earning Rate/Normal Earning Rate x paid-up value of shares

Rate of Earnings = Actual Profit Earned / Capital Employed x 100

Rate of earnings is calculated by taking into account the total capital employed including long-term borrowings. Since the total capital is taken into account the profit figure should be before debenture interest, preference dividend but after income tax. This is quite appropriate when the dividend is much more than the rate of earning on capital.

(b) Valuation Based on price Earning Ration: - This value is suitable for ascertaining the market value of shares which are quoted on a recognised stock exchange. According to this method, the shares are valued or the basis of earning per share multiplied by Price Earning Ratio. Thus

Market Value of Share = price Earning Ratio x Earning per share

Earning per Share = Profits available for Equity Shareholders/ No.of Equity Shares

Price Earning Ratio = Market Value per share / Earning per share OR

Price Earning Ratio = 100/Normal Rate of Return

(c) Valuation of Shares 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 Adjusted Taxed Profit/Average Weighted Net Worth x 100

Average profits and average net worth are ascertained by taking a number of years whose results are relevant to the future.

3. Dual Method 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 reliable which is an average of the two methods of valuation of shares. The formula for the valuation of shares according to the dual method is as follows;

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

pradeepkalari (pradeep sp)