Methods of Valuation of Shares – An Overview
Valuation of shares is a process done to know 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 share price, while unlisted companies are not the same. Due to this, share valuation techniques are used, which is equally important and challenging.
The valuation of shares is a process of determining the worth of a company’s stock. It involves assessing various factors and using different methods to determine a fair share value. This article explores several methods of valuation commonly used by investors and analysts.
Purpose of Valuation of Shares
A company would do a valuation of shares 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 its shares to another class.
- In the case of the shares are required to be done legally.
- When an investment company holds shares.
- Valuation should be done when the company implements 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 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 and discount on the issue of shares. Accumulated losses and other assets.
– Current assets and liabilities like receivables, payables, and provisions should be considered.
For computing the net value of assets, from the company’s total assets, 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 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 the Number of Equity Shares
2. Income Based
The income-based approach can be used when the valuation is done for a few shares. The benefits 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 widely used for the same is dividing the expected earning of the company by a capitalization rate.
The companies also use DCF, or Discounted Cash Flow, and PEC, or Price Earning Capacity Methods. Newly established or startup companies can use PEC. 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 and which is available for distribution. Reducing reserves and taxes from such net profit shall arrive at this profit. The steps which the company should follow 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
3. Market Based
The market-based approach uses the share price of the comparable publicly traded companies and the shares or asset values of the private companies, which can be compared with the same. Data about private companies can be availed from various proprietary databases currently available. 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 other factors.
The following two methods can be used under the market-based method:
1. Earning Yield
Here shares would be valued based on 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 of 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.
Book Value Method
The book value method calculates the value of shares based on the company’s net assets. It is determined by subtracting the total liabilities from the total assets and dividing the resulting figure by the number of outstanding shares. This method provides a conservative estimate of a company’s value and is commonly used for valuation in industries with substantial tangible assets.
Comparable Transactions Method
The comparable transactions method involves analyzing similar transactions in the market to estimate the value of shares. It considers recent mergers, acquisitions, or sales of companies with comparable characteristics. This method provides insights into the market valuation of similar businesses and is often used in industries with active mergers and acquisitions.
Liquidation Value Method
The liquidation value method determines the value of shares based on the net amount shareholders would receive in case of a company’s liquidation. It involves estimating the value of all assets and deducting liabilities and liquidation expenses. This method is relevant for companies in financial distress or industries with significant asset value.
Discounted Cash Flow Method
The discounted cash flow (DCF) method calculates the value of shares by estimating the present value of expected future cash flows. It involves forecasting future cash flows and discounting them to their present value using an appropriate discount rate. This method is widely regarded as a comprehensive valuation approach and is favoured by analysts for its ability to consider the time value of money.
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 other institution should consider all the metrics like the purpose and other factors before deciding.
1. Can I use multiple valuation methods simultaneously?
Yes, it is common to use multiple valuation methods to cross-validate the results and gain a comprehensive understanding of the value of shares.
2. Are these valuation methods applicable to all types of companies?
These methods can be applied to various companies, but their suitability may vary depending on the company’s industry, financial health, and specific circumstances.
3. Which valuation method is the most accurate?
There is no definitive answer to this question, as the accuracy of a valuation method depends on the assumptions, data quality, and expertise of the person conducting the valuation.
4. How often should I revalue shares?
The frequency of share valuation depends on the specific circumstances and requirements. Generally, revaluing shares periodically or when significant events or changes may impact the company’s value is advisable.
5. Can these methods be used for valuing privately-held companies?
While some methods are more commonly used for publicly traded companies, many can be adapted to value privately-held companies. However, additional considerations and adjustments may be required to account for the lack of market data and other factors.