Methods of Valuation of Shares

Methods of Valuation of Shares (5 Methods) 

Let us make in-depth study of the five methods of valuation of shares, i.e., (1) Asset Backing Method, (2) Yield-Basis Method, (3) Fair Value Method, (4) Return on Capital Employed Method, and (5) Price-Earning Ratio Method.

A. Asset-Backing Method:

Since the valuation is made on the basis of the assets of the company, it is known as Asset-Basis or Asset- Backing Method. At the same time, the shares are valued on the basis of real internal value of the assets of the company and that is why the method is also termed Intrinsic Value Method or Real Value Basis Method.

This method may be made either:

(i) On a going/continuing concern basis; and

(ii) Break-up value basis.

In the case of former, the utility of the assets is to be considered for the purpose of arriving at the value of the assets, but, in the case of the latter, the realizable value of the assets is to be taken. Under this method, value of the net assets of the company is to be determined first.

Thereafter, the net assets are to be divided by the number of shares in order to rind out the value of each share. At the same time, value of goodwill (at its market value), investment (non-trading assets) are to be added to net assets. Similarly, if there are any preference shares, those are also to be deducted with their arrear dividends from the net assets.

However, this following step should carefully be followed while calculating Net Assets or the Funds Available for Equity Shareholders:

(a) Ascertain the total market value of fixed assets and current assets;

(b) Compute the value of goodwill (as per the required method);

(c) Ascertain the total market value of non-trading assets (like investment) which are to be added;

(d) All fictitious assets (viz, Preliminary Expenses, Discount on issue of Shares/Debentures, Debit-Balance of P&L A/c etc.) must be excluded;

(e) Deduct the total amount of Current Liabilities, Amount of Debentures with arrear interest,” if any, Preference Share Capital with arrear dividend, if any.

(f) The balance left is called the Net Assets or Funds Available for Equity Shareholders.

The following chart will make the above principle clear:

Alternatively:

Net Assets = Share Capital + Reserves and Surplus Revaluation – Loss on Revaluation

Applicability of the Method:

(i) The permanent investors determine the value of shares under this method at the time of purchasing the shares;

(ii) The method is particularly applicable when the shares are valued at the time of Amalgamation, Absorption and Liquidation of companies; and

(iii) This method is also applicable when shares are acquired for control motives.

Illustration 1:

From the following Balance Sheet of Sweetex Ltd. you are asked to-ascertain the value of each Equity Share of the company:

For the purpose of valuing the shares of the company, the assets were revalued as: Goodwill Rs. 50,000; Land and Building at cost plus 50%, Plant and Machinery Rs. 1, 00,000; Investments at book values; Stock Rs. 80,000 and Debtors at book value, less 10%.

Intrinsic Value of each share = Funds available for Equity Shares/Total Number of Shares

Intrinsic Value of shares = Rs. 3, 30,000/20,000

= Rs. 16.50.

Intrinsic Value of Shares on the Basis of Valuation of Goodwill

Illustration 2:

X Ltd. presented the following Balance Sheet as on 31st March 2010:

Additional Information:

(a) Land and Building and Plant and Machinery were revalued at Rs. 15, 00,000 and Rs. 2, 28,000, respectively.

(b) Investments were valued at market value.

(c) Stock to be taken at Rs. 80,000 and Debtors subject to a deduction @ 10% for bad debts.

(d) Net profit (before Tax) for the last five years were: Rs. 50,000; Rs. 70,000; Rs. 80,000; Rs. 1, 00,000 and Rs. 1, 25,000.

(e) Managerial Remuneration Rs. 8,000 to be charged against profit for every year.

(f) Normal Rates of Return 10%.

(g) Goodwill to be valued at 5 years’ purchase of Super-Profit.

(h) Rate of tax 50%.

Ascertain the Intrinsic Value of Shares.

Intrinsic Value of Share and Ratio of Exchange of Shares:

Illustration 3:

The following Balance Sheets were presented by X Ltd. and Y Ltd. as on 31st Dec. 2008:

Solution:

(a) Calculation of Intrinsic Value of Shares:

(b) Calculation of Ratio of Exchange:

It can be calculated by two ways:

(i) Ascertain the L.C.M. of the intrinsic value of shares and the same is divided by the intrinsic values in order to get the ratio of exchange.

We know, L.C.M. of 20 and 10 is 20.

Thus, one share of X Ltd. is equal to two shares of Y Ltd. since value of X Ltd.’s share is Rs. 20 and that of Y Ltd.’s is Rs. 10.

So, we can say, the ratio of exchange is 1 share of X Ltd. is equal to 2 shares of Y Ltd.

(ii) Alternatively:

Net assets of Y Ltd. should be divided by the intrinsic value of X Ltd. in order to calculate the number of shares to be issued on the basis of which they said ratio can be ascertained.

Thus, the ratio of exchange is 5,000 shares of X Ltd. for 10,000 shares of Y Ltd. i.e., the ratio is 1 : 2 or 1 share of X Ltd. is equal to 2 shares of Y Ltd.

B. Yield-Basis Method:

Yield is the effective rate of return on investments which is invested by the investors. It is always expressed in terms of percentage. Since the valuation of shares is made on the basis of Yield, it is called Yield-Basis Method. For example, an investor purchases one share of Rs. 100 (face value and paid-up value) at Rs. 150 from a Stock Exchange on which he receives a return (dividend) @ 20%.

Under Yield-Basis method, valuation of shares is made on;

(i) Profit Basis;

(ii) Dividend Basis.

(i) Profit Basis:

Under this method, at first, profit should be ascertained on the basis of past average profit; thereafter, capitalized value of profit is to be determined on the basis of normal rate of return, and, the same (capitalized value of profit) is divided by the number of shares in order to find out the value of each share.

The following procedure may be adopted:

Illustration 4:

Two companies, A Ltd. and B. Ltd., are found to be exactly similar as to their assets, reserves and liabilities except that their share capital structures are different:

The share capital of A. Ltd. is Rs. 11,00,000, divided into 1,000, 6% Preference Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each.

The share capital of B. Ltd. is also Rs. 11,00,000, divided into 1,000, 6% Preference Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each. .

The fair yield in respect of the Equity Shares of this type of companies is ascertained at 8%.

The profits of the two companies for 2009 are found to be Rs. 1, 10,000 and Rs. 1, 50,000, respectively.

Calculate the value of the Equity Shares of each of these two companies on 31.12.2009 on the basis of this information only. Ignore taxation.

Illustration 5:

From the following information of J. Adams Co. Ltd. compute the value of its equity share by capitalisation of earning method:

It is the usual practice of the company to transfer Rs. 30,000 every year to General Reserve. Assume rate of Taxation is at 50% and the rate of normal earnings at 12.5%.

Show workings also.

(ii) Dividend Basis:

Valuation of shares may be made either (a) on the basis of total amount of dividend, or (b) on the basis of percentage or rate of dividend:

Whether Profit Basis or Dividend Basis method is followed for ascertaining the value of shares depends on the shares that are held by the respective shareholders. In other words, the shareholders holding minimum number of shares (i.e., minority holding) may determine the value of his shares on dividend basis since he has to satisfy himself having the rate of dividend which is recommended by the Board of Directors, i.e., he has no such power to control the affairs of the company.

On the contrary, the shareholders holding maximum number of shares (i.e., majority holding) has got more controlling rights over the affairs of the company including the recommendation for the rate of divided among others. Under the circumstances, valuation of shares should be made on profit basis. In short, Profit Basis should be followed in the case of Majority Holding, and Dividend Basis should be followed in the case of Minority Holding.

The same principle may be represented in the following form:

Note:

Yield-Basis Method may also be termed as:

Market Value Method; Profit Basis/Income Basis Method;

Earning Capacity Method etc.

Value of share under yield basis:

Illustration 6:

On December 31, 2009 the Balance Sheet of MA KALI Ltd. disclosed the following position:

Of which 20% was placed to Reserve, this proportion being considered reasonable in the industry in which the company is engaged and where a fair investment return may be taken at 10%. Compute the value of the company’s share under yield-basis method.

Illustration 7:

Calculate the value of each Equity Share from the following information:

C. Fair Value Method:

There are some accountants who do not prefer to use Intrinsic Value or Yield Value for ascertaining the correct value of shares. They, however, prescribe the Fair Value Method which is the mean of Intrinsic Value Method end Yield Value Method. The same provides a better indication about the value of shares than the earlier two methods.

Illustration 8:

The following is the Balance Sheet of X Co. Ltd. as on 31.12.2009:

Ascertain the value of each equity share under Fair Value Method on the basis of the information given:

Assets are revalued as:

Building Rs. 3, 20,000, Plant Rs. 1, 80,000, Stock Rs. 45,000 and Debtors Rs. 36,000. Average Profit of the company is Rs. 1, 20,000 and 12½% of profit is transferred to General Reserve, Rate of taxation being 50%. Normal dividend expected on equity shares is 8% whereas fair return on capital employed is 10%. Goodwill may be valued at 3 years’ purchase of super-profit.

D. Return on Capital Employed Method:

Under this method, valuation of share is made on the basis of rate of a return (after tax) on capital employed. Rates of return are taken on the basis of predetermined/expected rates of return which an investor may expect on the investments. After ascertaining this expected earnings, we are to determine the capital sum for such a return.

Thus, we are to follow the following procedure one by one:

(a) Ascertain the expected (maintainable) profit (after adjustments, if any);

(b) Ascertain the normal rate of return on capital employed for a similar business;

(c) At last, on the basis of expected rate of return, capitalize the (maintainable) profit.

Illustration 9:

Ascertain the value of each equity share under Return on Capital Employed Method from the following particulars:

E. Price-Earnings Ratio Method:

We know that it is the ratio which relates the market price of the share to earning per equity share.

It is calculated as:

Illustration 10:

Compute the value per share and valuation of the business from the following particulars: