Valuation of Shares: Need and Methods (With Illustrations)

In this article we will discuss about the Need and Methods required for Valuation of Shares.

Need for Valuation of Shares:

In most cases, shares are quoted on the stock exchange; and for ordinary transactions in shares or debentures or Government securities, the price prevailing on the stock exchange may be taken as the proper value.

The stock exchange price does not hold good for very large lots. And not all shares are quoted on the stock exchange. Shares of private companies in any case will not be quoted. If, therefore, shares of such a company have to change hands, the value of such shares will have to be ascertained.

In addition, in the following circumstances, need arises for valuation of shares of a company:—

(a) For formulating an amalgamation scheme.

(b) For purchase or sale of controlling shares (stock exchange quotations are valid only for regular lots).

(c) For the valuation of the assets of a finance or an investment trust company.

(d) For security purposes, e.g., where loans are raised on the security of shares of a company.

(e) Where a company is reconstructed under section 494 of the Act and there are dissentient shareholders.

(f) Where a company acquires the shares in a company under section 395—that is when 9/10ths of shareholders in a company agree to transfer shares to another company and the transferee company decides to acquire the shares of dissentient shareholders also.

The factors that affect the value of shares of a company are similar to those that affect the value of goodwill of the company. In fact, valuation of goodwill and valuation of shares are inter-related.

The normal rate of return, though determined largely in the same way as in case of goodwill, has to be viewed in the light of some other factors also which are mentioned below:—

(i) Restrictions on transfer of shares — the normal rate of return will be increased, say, by ½%.

(ii) Disabilities attaching to the share will also cause the normal rate of return to go up — for instance, if the share is partly paid, the investors will expect a high yield from it (say, by ½% higher) than in case of fully paid shares.

(iii) Dividend performance — investors are satisfied with a comparatively low yield in case the company declares a uniform dividend from year to year and does not make a default. The normal rate of returns higher when the dividends have been fluctuating.

(iv) Financial prudence is also a factor. A company which distributes only a part of profits will attract investors without having to offer high yield.

(v) Net asset backing is important from the point of view of safety. If tangible assets per share, after deduction of all liabilities, are twice or thrice the paid up value of the share, investors will be satisfied with a lower rate of return than if the net tangible assets are only a little more than the paid up capital.

Methods for Evaluating the Value of Shares:

Net Assets Basis or Intrinsic Value:

In this case, the net assets of the company are determined and then the figure is divided by the number of shares. Care must be taken to value goodwill. Non- trading assets will also be included. The assets will be put down at their market value.

If there are preference shares, the preference capital will be deducted and only the remainder will be available for the equity shareholders. The figure will then be divided by the number of equity shares and the result will be the intrinsic value of the shares.

For example, taking illustration, the intrinsic value of equity will be determined as follows:—

Illustration 1:

The following are the balances taken from the balance sheet of John Engineering Ltd. as on 31st March, 2012:

The dividend on equity shares should be calculated, (a) by deducting from maintainable profits: (1) taxation, (2) transfers to reserves (3) transfers to debenture redemption fund and (4) preference dividend; and (b) dividing the remainder by the number of equity shares.

The market value of preference shares will also be calculated in the manner indicated above but the normal rate of return in case of preference shares will be lower than in the case of equity shares because there is priority both as regards dividend and as regards return of capital.

If the net assets of the company are not ample to cover the preference capital, investors will expect a higher yield than ordinarily. Investors feel happy if the net assets are about three times the preference capital.

In order to give weight-age to the part of profits not distributed, one-third or one-half of the undistributed profit may be added to the amount actually distributed and then the ‘dividend’ per share is ascertained.

This will increase the value of shares of companies which build up reserves. However, the method of calculating value of shares on the basis of dividends declared will always put a premium on the shares of companies which distribute a larger part of their profits. This is clearly unsatisfactory, since it seems to reward lack of prudence. The method discussed below gives a better picture.

Illustration 2:

From the following information, calculate the value of an equity share:

(i) The subscribed share capital of a company consists of 10 lakh 13% preference shares of Rs 10 each and 20 lakh equity shares of Rs 10 each. All the shares are fully paid up.

(ii) The average annual profits of the company after providing depreciation but before taxation are Rs 1,80,00,000. It is considered necessary to transfer Rs 34,50,000 to general reserve before declaring any dividend. Rate of taxation is 30%.

(iii) The normal return expected by investors on equity shares from the type of business carried on by the company is 20%.

Illustration 3:

C. Ltd. started its business on 1st April, 2009. On 31st March, 2012, its balance sheet in a summarised from was as follows:

Illustration 4:

From the following particulars, calculate the fair value of an equity share assuming that out of the total assets, those amounting to Rs. 41,00,000 are fictitious.

Illustration 5:

On march 31, 2012, the balance sheet of Harsh Ltd. disclosed the following position.

An Alternative Treatment:

Another method of valuing shares is based on earning per share (EPS) or net profit per equity share multiplied by the price earning ratio (PE Ratio). The PE Ratio is really the converse of the normal rate of return applicable to the company. For example, if the normal rate of return is 20%, the PE Ratio will be 5 i.e. 100 – 20. If the net profit per share or EPS is Rs 7, the price of the share will be, for the PE Ratio of 5, Rs 35.

The above is a simple way of stating the point made already except that instead of dividend per share net profit per share is taken. One can see that if either of the two factors, EPS or PE ratio changes, the price of the share will change. In the example given above, if the PE ratio becomes 4 i.e., normal rate of return is 25%, the share will be valued at Rs 28.

The PE Ratio is high where risk is low and low when risk is high, say, when in the capital employed loans preponderate.

Value based on Earnings of the Company:

Often, the dividend declared by a company is much less than the rate of its earning. Since accumulated profits are likely to be distributed sooner or later, in the form of bonus shares, usually the market price is likely to be based on the earnings of the company rather than the dividend. This provides a firm basis for valuation of shares, since this relates the value to the real efficiency, as measured by profitability of the company. The formula is:

It should be based on total capital employed (including long-term borrowings) and the profit figure should be before debenture interest, preference dividend, etc., but after income-tax. This valuation is quite appropriate for large blocks of shares; also when the dividend is much more than the rate of earning on capital.

Illustration 6:

Mr. Aggarwal who desire to invest Rs. 33,000 in equity shares in a public limited company seeks your advice as to the fair value of the shares. The following information is made available.

Illustration 7:

Tee Ltd. belong to an industry in which equity shares sell at per on the basis of 18% yield provided the net tangible assets of the company are 250% of the paid up capital and provided the total distribution of profits dose not exceed 50% of the profits. The dividend rate fluctuates from year to year in the industry.

The balance sheet of Tee Ltd. stood as follows on 31st March, 2012:

Illustration 8:

Capital structure of Lot. Ltd. as at 31.3.2012 was as under:

 

Illustration 9:

Balance Sheet of A Ltd. as on 31.3.2012 was as under:

Illustration 10:

Surya Ltd. and its subsidiary Chandra Ltd. get their supply of some Raw Material from Akash Ltd. To coordinate their production on a profitable basis Surya Ltd. and Akash Ltd. agree between themselves each to acquire a quarter of shares in other’s Authorised Capital by means of exchange of shares.

The terms are as follows:

Illustration 11:

You are asked to value shares as on 31st March, 2012 of a private company, engaged in engineering business, with a view to floating it as a public company.

The following information is extracted from the audited accounts:

 

 

Illustration 12:

Below is given the Balance Sheet of Devta Ltd. as at 31st March, 2012:

Illustration 13:

Under the articles of a private company dealing in wines and tabacco, you as an auditor, have to fix annually the fair value of the shares.

At 31st March, 2012 Company’s position was as follows:

The safest (long term) value that can be put on the equity shares is that on the basis of earnings ratio — the other two values have some unnatural elements. Intrinsic value is not relevant, since those who invest in shares do not have much interest in the assets behind the shares; they are interested in the income.

The market value based on maximum possible dividends is also unnatural since few companies will distribute all the profit earned by them — probably they will distribute only what the capital has earned. Hence, the value based on earnings ratio seems to be the fairest.

The value of the preference shares is likely to be Rs 100 as the assets available are more than sufficient to cover the shares and moreover, the company is earning good profits to ensure payment of dividend on the preference shares regularly.