From a company’s standpoint, both its shares and goodwill are critical assets. Goodwill represents a long-term asset that produces value over time, resulting from the company’s brand value, consumer base, and intellectual property reputation. In addition, shares show ownership in a company, help with market capitalization, collect funds for growth and operations, and increase the size of the company.
Share valuation is vital in establishing a fair market price and enabling investors to make sound decisions about purchasing or selling shares. It is the method of ascertaining the intrinsic value of the company. The valuation of a company’s goodwill acts as a metric for its longstanding performance as well as its capacity to deliver future earnings.
Let us look at what the valuation of shares and goodwill means, the need for valuation, the factors that impact valuation, the different valuation methods, and the advantages of valuation.
What is the Valuation of Shares
The valuation of shares decides the current worth of a company stock which emanates from its financial soundness, assets, liabilities, and market success. It benefits investors by letting them know whether a stock is a good purchase depending on its actual value. The share valuation process gives you the fair value of a company’s stock at a price that is neither too high nor too low.
For share valuation you require an estimate of a company’s net worth applying separate mathematical methods. Appraisers consider the financial details of a company such as present income and cash flows, capital management, assets, and future finances, to figure out the firm’s current value.
The Need for Valuation of Shares
There can arise a need for valuation of shares under the following conditions:
- Capital raising and promoting investment decisions
- Guaranteeing fair pricing in mergers and acquisitions, amalgamation, and reconstruction
- Tax compliance and assessments as per the Wealth Tax Act or gift tax
- Resolving litigation and disputes where the valuation of shares is a legal necessity.
- Shares owned by an investment firm
- Company shares conversion from preference to equity
- Approaching for a bank loan pledging shares as a security
- Selling your business and knowing its value
- Enforcing an employee stock ownership plan (ESOP)
- Repaying the shareholders if the company is nationalized
- Ensuring proper financial reporting as share valuation influences balance sheet and income statements
- Implementing risk management planning
Factors That Impact the Valuation Of Shares
There are numerous factors that influence the valuation of shares. These include:
- Financial performance includes cash flows, income, sales, rate of growth, and profitability. Overall, the valuation of shares rises with its financial performance.
- Higher risk and unpredictability of the company lead to depreciation in share valuation.
- The Market Price of the share affects its relative valuation. Multiples, such as P/E and P/B, apply the share or equity price based on demand and supply, investor sentiment, and performance.
- Dividend Policies are companies that pay regular dividends or raise them, which attracts investors. Dividend accruals raise the stock price, while a decline in dividends tends to reduce prices.
- Economic conditions, such as a recession with high interest rates, inflation and declining demand, impact a company’s short and medium-range performance. Share valuation fluctuates during this period.
Methods Applied For Share Valuation
These are the various accepted methods for share valuations that investors and market analysts apply.
1. Asset -Based Valuation
This method considers all assets and liabilities, including contingent liabilities and intangible assets. Here, the net asset value is evaluated to estimate the share value.
Value per share = (Net Assets – Preference capital) / total number of equity shares
This method is preferred by manufacturing companies with an enormous asset base.
2. Discounted Cash Flow (DCF)
The DCF method uses an income-based procedure for valuation. This model discounts cash flows likely in the future to estimate the company’s actual value. Using this method, the true value is identified by predicting 5-10 years of future cash flows. Next, calculate the terminal or continuing value to represent all cash flows in the future exceeding the forecast duration. After that, discount all such cash flows till the present time to assess the fair value of the company.
3. Price to Earnings Ratio P/E
The P/E ratio is a relative valuation process that represents the amount a shareholder prefers to pay per Rs. 1 of income. You can conveniently analyze the P/E ratios of companies in the same industry to determine the fair share value.
4. Price to Book Value Ratio (P/B)
This denotes the ratio of the market value of a company and its book value. The book value comprises the value of assets of a date after depreciation is considered. The price of the share is its market value. Normally, the best P/B ratio signifies a value below one.
5. Enterprise (EV) Multiple
EV/EBITDA denotes a measure to assess a company’s value utilizing its market value and profit making.
EV multiple = EV/EBITDA
EV or enterprise value means the total value of the company
EBITDA represents the profit that the company makes from the sale of its merchandise and services.
There is no specific thumb rule for picking the valuation. Like for instance the pharmaceutical or FMCG industry find the discounted cash flow procedure highly suitable. Whereas, the insurance or banking company rely on the P/E ratio method.
What is the Valuation of Goodwill
Goodwill comprises an intangible asset in the form of a brand name, consumer associations, customer base or any proprietary technology or patents.
A company’s goodwill is its ability to achieve positive recognition from the clients due to its quality and standards. A happy customer will return to the firm repeatedly, thus aiding the firm in developing a solid customer base that generates more significant profit in the future. Therefore, Goodwill comprises the market worth of the firm’s reputation, which allows it to earn a premium above the standard profit earned by different firms in a similar industry.
The valuation of goodwill is based on the valuer’s assumption. A flourishing business earns a name in the industry, builds trust with its customers, and has more vast business links, in contrast to new companies. All these aspects count while assessing the business, and the financial value that a consumer is willing to give is termed goodwill.
Customers who purchase a company and view its Goodwill expect to make super-profits. Thus, Goodwill is concerned only with firms that gain super-profits and excludes those that earn periodic losses or profits.
Need for Valuation of Goodwill
The need for valuation varies according to the form of business enterprise.
- Admission of a Partner
- Amalgamation
- Sale of the Business
- Death of the Sole Trader
- Alterations in the Profit-exchanging Ratio
- Conversion into Company
- Admission, Death, Retirement of a Partner
- Amalgamation or Dissolution
Joint Stock Company
- Purchase or Sale of Company
- Government Takeover
- Absorption or Amalgamation of Company
- Valuation of Shares
- Goodwill Account displaying at Fair Price apart from being written-off
- Regulating Interest in another company
Factors that Impact the Valuation of Goodwill
Goodwill is a conglomerate of different factors or components as specified below:
- Time: The reliability of aged businesses is greater than the current ones.
- Location: Firms located at more attractive locations tend to attract more clients than those at less attractive places.
- Owner’s Reputation: Customers who do not trust a reputation may lose their credibility in the firm.
- Profit Trends: The up and down profit trends may be a determining factor in the purchasing behaviour of the customer.
- Nature of Business: The nature of business comprises the product types offered by it, the concerned risk, and reach to raw materials.
- Market Circumstance: The economy is dynamic, and product demand keeps varying. As a result, the product price rises and sales decrease.
- Consumers and Industrial Relations: This is a critical factor since a happy customer creates sales. Favourable industrial relations also develop trust in the market.
- Processes and Product Quality: Superior product quality and performance generate a reassuring image in the consumer’s mind, which helps maintain goodwill.
- Competition: Improved customer service compared to its rivals enhances the firm’s reputation within the market.
Methods of Goodwill Valuation
Valuation of goodwill uses various methods adapted to specific business situations and industry practices. The leading three approaches for goodwill valuation are specified below:
Average Profits Method
This method includes two subdivisions.
Simple Average: Goodwill is measured by calculating the average profit over a specific number of years, termed years of purchase.
Goodwill = Average Profit x Number of years of purchase.
Weighted Average: The past year’s profit is measured with specific weights. It is helpful when there are differences in profits, highlighting the profit of the current year.
Goodwill = Weighted Average Profit x Number of years of purchase, in which Weighted Average Profit = (Sum of Profits x weights)/ Sum of weights.
Super Profits Method
This method concentrates on the surplus of anticipated future maintainable profits above-average profits. It has two techniques.
Purchase Method by No. of Years: Goodwill is measured by assessing super-profits over a certain number of purchase years.
Super Profit = Average or Actual profit – Normal Profit.
Annuity Method: The average super profit is an annuity value over a specific number of years. The present value of this annuity at a specified interest rate is measured.
Goodwill = Super Profit x Discounting Factor.
Capitalization Method
This method includes two approaches.
Average Profits Method: Goodwill is calculated by deducting the initial capital from the capitalized sum of average profits based on the average return rate.
Capitalized Average Profits = Average Profits x (100/average return rate).
Super Profits Method: Super profit is capitalized to measure Goodwill.
Goodwill = Super Profits x (100/Standard Rate of Return).
Conclusion
Both shares and goodwill comprise valuable assets and their valuation is significant in determining a company’s overall worth. Proper share and goodwill valuation guarantees the maintenance of proper pricing in dealings which benefits both the shareholders and the company. Suppose you need clarity about valuation methods or looking for solutions, we at kanakkupillai.com are always eager to help you out.
