Valuation of Shares

VALUATION OF SHARES

Need for the valuation of shares.

When two or more companies amalgamate or one company absorb another company

When a company has decided to undergo a process of reconstruction

When preference shares or debentures are converted into equity shares

Shares are often pledged as security for raising loans

When one company acquires majority of the shares of another company it is necessary to value such shares.

The survivors of deceased person who get some shares of company made by will,

Under a scheme of nationalization when the shares of a company are taken over by the government.

Method of Valuation of shares

Method of valuation of shares depends on the purpose and factors affecting the valuation of shares

There are certain judicial decisions with regard to valuation of shares.

The Bombay High Court (ITR 799) concluded that in a company which is running concern, the market value of shares is determined mainly on the basis of the yields methods because a person who holds the shares or who want to purchase shares does it in the hope of getting the adequate return on his investments.

The Supreme courts (ITR 38) held that where the shares of Public limited company are not quoted on any stock exchange or shares of the private company, the proper method of valuation of shares would be the profit earning method.

The court has laid down following principles for share valuation

Where the shares in the public limited company are quoted on the Stock Exchange, the price prevailing on the valuation date is the value of shares.

Where shares are of private company or of a public company which are not quoted, the value is determined by reference to the dividend reflecting the profit earning capacity on a reasonable commercial basis. Otherwise the amount of yields would determine the value of the shares.

Where the total Yield and earning method breakdown by reasons of the company’s inability to earn profit and declare dividends. In that case value would be discounted by the percentage corresponding to proportionate fall in the quoted prices

Where expense are incurred out of proportion to the commercial venture these would be added back to the profit while computing yields. In case of private companies the restriction on the transfer of shares would be taken into account in arriving at the value of shares.

Various Methods

of valuation of shares

I. Net Assets value (NAV) Method

This method is called also called Intrinsic Value Method or Break up value method or Asset Backing method.

Under this method the net assets (assets-liabilities) are calculated and divided by the number of the shares to get the “net assets value “per share.

To determine the “intrinsic Value” (Net Assets Value) of equity shares the claims of preference shareholders must be deducted.

The claims of preference shareholders include the paid up value of preference shares and arrears of dividends thereon (for cumulative preference shares).

If Preference shares have a right to participate in the surplus (as it happen in case of liquidation) the amount should also be deducted and included in the preference shareholders claims

Equity shares with different paid up values

The company has issued shares with different face values

The company has issued shares with only one face value but with different paid up value.

The company has issued shares with different face values

The value of equity shares shall be calculated on the basis of “unit value” of capital.

The unit value will be multiplied by the paid up value of different lots to get the intrinsic value per share.

The company has issued shares with only one face value but with different paid up value.

The value of equity shares shall be determined after the notional call

The total net assets will be divided by the total number of equity share

This will give the value of each fully paid equity share

Unpaid amount of each share will be deducted from each value to ascertain the value of partly paid up shares

Valuation of Preference shares

A preference shareholder is particularly interested in the security of capital and consistency of returns.

That is why he is anxious for a priority of repayment of his capital/dividend or both.

The following points must be kept in the mind while calculating the value of preference shares.

If preference shares are non-cumulative and non-participating the value of each preference shares shall be equal to its paid up value

If preference shares are cumulative and non-participating the value will be determined after arrears of preference dividend are added back to their paid up capital

In the case preference shares are cumulative and participating then besides arrears they will also be entitled to shares in the surplus of the company, left after returning equity capital.

However, if the preference shares do not have any preference (priority) with regard to repayment of capital and dividend, the values of preference shares shall be calculated as if these are equity shares

II. Yield Method

This method takes into account the future prospects in terms of return on investment.

This method is based on the assumption that the company is going concern. It will continue its activity year after year. Therefore, value of shares is based on the Dividend yield or Earning yield

Dividend yield

When the shareholder has little or no influence over dividend policy valuation of shares may be based on dividends. Following points should be consider while deciding profit available for equity dividends.

Average profits Provision for depreciation, taxation and other

liabilities payable. Provision for preference dividend. Transfer to General reserve

Procedure

Find out the F.M.P.

Particular Amount Amount

Average profit xx

Add: Expenses & losses incurred so far, but not likely to be incurred in future xx

Add: Income & Gain not earned so far, but likely to be earned in the future xx

xxx

Less: Expenses & losses not incurred so far, but likely to be incurred in future xx

Less: : Income & Gain not earned so far, but likely to be earned in the future xx xx

xxx

F.M.P.

=F.M.P. after taxation-Preference dividend- Transfer to reserve as under law contracts

Decide the rate of F.M.P./Expected rate of dividend

Rate of F.M.P.

= F.M.P X 100

paid up equity capital

Work out yield value

Rate of F.M.P. X Amount paid per share

Normal rate of return

Value of share can be calculated as

Rate of dividend X Paid value of share

Normal rate of return

or

Dividend per share X 100

Normal rate of dividend

Earning yield

Under this method share are valued on the basis of earning expected. Earning are expected are calculated on the basis of average recent years profits following steps should be taken:

Find out the profit after tax Calculate expected rate of ratings

= Profit after tax X 100

Paid up value of shares

Work out the value of shares

= Expected rate of earning X face value of shares

N.R.R.

III. Earning Capacity Method

This method takes into account the earning potentials of a company rather then return of the shareholders.

The earning capacity method takes into account total earning of the company before any appropriation.

This method involves the following steps.

Calculation of future maintainable profits. Calculation of capital employed. Ascertaining the rate of earnings. Determining the normal rate of return. Determination of value of shares.

Calculation of capital employed

The capital employed should mean Equity capital employed as i.e. Equity capital plus retained earning. The preference share capital, The Long term borrowing and debentures were to be excluded.

Ascertaining the rate of earnings

Rate of earning

= Profits after interest, tax & preference

dividend X100

Equity capital

Determination of value of shares

Value of Equity shares

= Earning Rate X Paid up value

Normal rate of return

IV. Capitalization of Earning Capacity Method

Under this method profits available for equity shareholders as calculated under capitalization of method, are capitalized on the basis of normal rate of return.

Then the value of equity shares is ascertained by dividing the capitalized profits by the number of equity shares as shown under

Capitalised Value of profits

= Future Maintainable Profits X100

Normal Rate of Return

Value of Equity shares

= Capitalised value of Profits

No. of equity shares

V. Fair value method

Fair value is simple an average of Intrinsic value and yield value or Earning capacity method.

Fair value of shares

= Intrinsic values + Yield value

2

Or

= Intrinsic value + Capitalised/Earning capacity

2