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The Concept of Share Valuation of Companies

Savvy Midha

| Updated: Oct 03, 2019 | Category: Startup

Share-Valuation

The valuation of shares involves finding out the value of a company’s shares. The share value of the listed entity whose shares are floating and traded on the stock market can be evaluated easily. Valuation of Shares varies depending upon the demand and supply of shares in the market, and the valuation is done based on quantitative techniques. However, in the case of private companies, whose shares are not publicly traded, the valuation of shares becomes difficult and challenging. 

The Requirement of Share Valuation

Share Valuation is required in case of the following incidences:

  • When a company is on the verge of being sold and the buyer as well as the company, need to know the actual worth of the company’s business in terms of the value of its shares.
  • For obtaining loans from a bank by creating a charge on shares as a security.
  • In case of a merger, amalgamation, takeovers, acquisition, etc.
  • In the case of the conversion from preference shares to equity shares.
  • When the company issues shares through Employee Stock Option Plan (ESOP).
  • For tax assessments to be conducted under the Gift Tax Act[1].
  • As a legal requirement, for instance, in the case of litigation.
It is important to note that market quotation does not always present the accurate picture of the value of shares and that’s why sometimes the valuation of publicly traded shares is also required to be conducted using a suitable approach and methods as explained in detail in the article henceforth.

The Approach to Share Valuation

The selection of a suitable method for share valuation generally depends upon the purpose of such valuation. Combining two or more methods for the valuation of shares provides a more reliable valuation. Following are the approaches usually resorted to:

  1. Asset Approach: Asset-based approach is used in case the company is:
  2. Capital-Intensive; or
  3. Has Invested large amount in capital assets; or
  4. Has the large volume of capital work in progress

Other than the above, this approach is applied by a company for the valuation of shares, in case the company is undergoing amalgamation, merger, or absorption.

  • Income Approach: Following two methods are used to evaluate the shares under this approach:
  • Discounted Cash Flow Method: The value of shares is determined based on the projection of future cash flow. 
  • Price Earning Capacity Method: This method makes use of the historical earning pattern to value the shares. This method is, however, not feasible for an entity that has not been in existence for a long time.
  • Market Approach: This approach is more feasible for the listed entity whose shares are listed and traded on the stock market because as per this approach, shares are valued based on the prevailing market price of shares.

Methods of Share Valuation

Different methods for valuation of shares can be used depending upon the purpose, the available data, nature of the company, etc.:

  1. Asset-Based Method: This method of valuation is based on the value of the company’s assets & liabilities inclusive of intangible assets & contingent liabilities. This method is useful in entities engaged in manufacturing, distribution, etc. as they are engaged in a huge volume of a capital asset.

Value per Share =     Net Assets – Preference Share Capital

                                         Number of Equity Shares

Key- Points of Consideration:

  • All the current assets and liabilities such as receivables, payable, provisions, etc. should be considered
  • Fixed assets are considered at their realized value
  • It is important to evaluate intangible assets such as goodwill.
  • Unrecorded assets and liabilities are also considered
  • No fictitious asset shall be considered. Preliminary expenses, discount on issue of debentures, accumulated loss, etc. are called a fictitious asset.
  • All the external liabilities are deducted from the total assets to calculate the Net Assets.

2. Income-Based Method: This method is used when a very small number of shares are required to be evaluated. The main focus is on what the business will generate in the future. Business value is estimated by dividing the expected earnings by a capitalization rate. The value of shares is calculated based on the profit of the company available for distribution. Gross profit is calculated by deducting reserves and tax from net profit.

Value of Shares =       Capitalized Value

                                     Number of Shares

Capitalized Value = Profit available for Dividend  

                             __________________________     x  100

                                     Normal Rate of Return              

3. Market-Based Method: Following are the two methods of market-based valuation of shares:

  •  Earning Yield Method: As per this method, the value of a share is calculated based on the expected earning and the normal rate of return. The formula used for it is:

1) Value per Share =               Expected rate of earning    

                                            ______________________    x Paid-up Equity Value

                                               Normal Rate of Return                    

2) Expected rate of earning     =         Profit after tax    

                                                      ____________       X 100

                                                        Paid-up Equity Value      

  • Dividend Yield Method: As per this method, the valuation of shares is done based on expected dividend and normal rate or return as per the following formula:

1) Value per Share =                   Expected Dividend     X Paid-up Equity Value

                                                  Normal Rate of Return                     

2) Expected rate of dividend     =        Profit available for Dividend     

                        X 100                         Paid-up Equity Value        

Book Value of Equity per Share

Book Value is different from the market value in terms that book value uses the historical cost while market value is a forward-looking mechanism that considers the future earning potential of a company.

The book value of securities is compared with that of market value to ascertain whether the price is overvalued or undervalued. In case the book value of shares is higher than the market value of shares, the stock price is said to be undervalued.

In the event of liquidation, when all the assets are sold, and the liabilities are paid, shareholders get the book value for their holdings. All the assets would be sold at the market price which is the prevailing price in the market, and therefore the market price is considered as a better floor price as compared to book value(that uses the historical cost of assets).

Key-Points

  • The book value of assets indicates the net asset value. Net asset value is the difference between the total assets and total liabilities on a per-share basis.
  • In case the stock is undervalued, book value will be higher as compared to the current market price.
  • The method is used by investors to evaluate the company’s current stock price.

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Savvy Midha

"Savvy Midha holds the degrees of Bachelor of Commerce(honors), LL.B and Company Secretary. She is an experienced Legal and Financial writer with expertise in research, drafting, and copy-writing."

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