Methods of Valuation of Shares – An Overview
Valuation of shares is a process that is done for knowing the value of the shares. Generally, the value of a share depends on the market demand and supply for the shares of a company, and valuation of this shall be done using various quantitative techniques.
In the case of listed companies, it is easy to know the price of the shares, while the case of unlisted companies is not the same. Due to this, the share valuation techniques are used which is equally important and challenging.
Purpose of Valuation of Shares
Valuation of shares would be done by a company during the following circumstances:
- During amalgamations or absorption
- Advancing loans on the security of shares of the company by banks.
iii. When a company wants to convert one class of their shares to another class.
- In case of the shares are required to be done legally.
- When shares are held by an investment company.
- Valuation should be done when the company is implementing ESOP or Employee Stock Options Plan.
Methods of Valuation of Shares
There are multiple valuation methods of shares and one should choose the same based on the availability of data, the purpose nature, and size of the company, or such other factors. Some of these methods include:
1. Asset Based
The asset-based method is a method that is useful for big companies with huge capital assets like manufacturers, distributors, etc. And is an approach that is based on the value of the company’s assets and liabilities. This also includes contingent assets and contingent liabilities. Under this method, the net assets value is divided by the number of shares such that the value of each share would be derived.
While valuing shares using the asset-based method, the following points should be considered:
– Consider the unrecorded assets and liabilities.
– Fixed assets should be considered at their realizable value.
– Goodwill should be valued as a part of the intangible assets.
– Eliminate the fictitious assets like the preliminary expenses, discount on the issue of shares. accumulated losses and such other assets.
– Current assets and liabilities like receivables, payables, and provisions should be considered.
For computing the net value of assets, from the total assets of the company, all external liabilities should be deducted.
Net Value of Assets = Total Assets of the Company – External Liabilities (if any)
Now such net value of assets derived should be divided by the number of equity shares such that the the per-share value shall be derived. The formula would be as below:
Value per Share can be computed as, Net Assets less by Preference Share Capital and divided by Number of Equity Shares
2. Income Based
The income-based approach can be used when the valuation is done for a small number of shares. The benefits which are expected from the investment made in the business are calculated or valued here. We can say that this is nothing but what the business would generate in the future. The formula which is widely used for the same is dividing the expected earning of the company by a capitalization rate.
DCF or Discounted Cash Flow and PEC or Price Earning Capacity Methods are also used by the companies. PEC can be used by newly established or start-up companies. While companies with volatile short-term earnings expectations can use more complex analyses such as discounted cash flow analysis or DCF.
Value per share of the company would be based on the profit earned by the company and which is available for distribution. This profit shall be arrived at by reducing reserves and taxes from such net profit. The steps which should be followed by the company for an income-based approach are given below:
– Compute the company profit which is available for distribution,
– Obtain the capitalized value data, and
– Compute the shared value using:
Capitalized Value/Total Number of Shares
Here, capitalized value can be computed by using the following formula:
Capitalized Value = (Profit Available for Equity Dividend/Normal Rate of Return) *100
iii. Market Based
The market-based approach uses the share price of the comparable public traded companies and also the shares values or asset values of the private companies which can be compared with the same. Data pertaining to the private companies can be availed from various proprietary databases which are available currently in the market. And for choosing the companies which can be compared, the following should be kept in mind:
– Nature and volume of business,
– The industry to which it belongs,
– Size of the company,
– Financial condition of the company and such other factors.
The following two methods can be used under the market-based method:
1. Earning Yield
Here shares would be valued on the basis of the normal rate of return and the expected earning of the company. For computing value per share, the following formula shall be used:
Expected Rate of Earning = (Profit After Tax/Equity Shares Paid-up Value) *100
Value per Share = (Expected Rate of Earning/Normal Rate of Return) *Paid-Up Equity Value
2. Dividend Yield
Under this method, the value of the share shall be computed using the expected rate dividend and normal rate of return. And the formula used would be as below:
Expected Rate of Dividend = (Profit Available for Dividend Distribution/Paid-Up Equity Share Capital) *100
It is to be noted that the normal rate of return is nothing but the computation of the profits made from an investment after subtracting the capital, investment, and operating cost.
Now, we can conclude that the valuation of shares is in fact the valuation of the company, its earning, and assets as a whole. It helps the equity shareholders understand the value of their investment or wealth and the growth they can expect. But while choosing the valuation method for shares, the company or such other institution should consider all the metrics like the purpose and such other factors before making a decision.