Valuation of Shares Need for Valuation of Shares

Valuation of Shares

Need for Valuation of Shares Need for valuation of shares arises under following circumstances : • Assessments under estate duty, wealth tax, gift tax etc. • Purchase of block of shares generally involving acquisition of controlling interest in the company • Formulations of schemes of amalgamations, absorption etc. • Acquisition of interest of dissenting shareholders under reconstruction scheme • Conversion of preference shares into equity shares • Advancing loans on the security of shares • Compensating shareholders on the acquisition of their shares, by the government under the scheme of nationalism

Valuation and Stock Exchange Prices � In case shares are quoted on a recognised stock exchange, stock exchange prices are generally taken as basis for valuation of those shares � However, the stock exchange quotations are not generally acceptable when a large block of company’s shares is involved because stock exchange price is basically determined on interactions of demand supply and business cycles. They can’t form fair and equitable and rational basis for compensation Net Assets Backing method Methods of valuation Yield Method

Nets Assets Backing Method Also termed as balance sheet method or asset backing method or intrinsic or break up value method � Asset backing for each share = net assets/ number of issued shares � Important points to be kept in mind while using this method i. Fictitious assets should be excluded ii. All other assets (including non-trading assets like investments) should be taken at their market values. In the absence of information about the market values , book values may be taken iii. Proper value should be placed on the goodwill of the business iv. Liabilities payable to third parties and preference share capital should be deducted from total assets �

CONTD. v. vii. Items constituting part of equity shareholders’ funds (e. g. general reserve, P&L credit balance, debentures redemption fund, dividend equivalisation reserve, contingency reserve etc. ) In case of equally paid up shares, value of share = net assets/ number of issued shares In case shares are of different paid up values , the total net assets should be allocated to different paid up value groups. Each such allocation should then be divided by number of shares in each of such groups

Value of equity share according to net assets backing method Goodwill as valued ---- Investments at market value ---- Other assets at market value ---- Less : debentures accounts payable other liabilities preference capital ----------------- Net assets available for equity shareholders (i) ----- Number of equity shares (ii) ----- Value of an equity share (i)/(ii) -----

Example : The following particulars relate to a company : Rs. Total assets 18, 50, 000 External liabilities 2, 50, 000 Share capital : 14% preference shares of Rs. 10 each, fully paid 40, 000 equity shares of Rs. 10 each, fully paid 60, 000 equity shares of Rs. 10 each, Rs. 7. 50 paid 5, 00, 000 4, 50, 000 Calculate the value of each category of equity shares of the company based on a deemed liquidation

Asset-Basis Value of an Equity Share Rs. Total assets 18, 50, 000 Less : liabilities 2, 50, 000 Net worth 16, 000 Less : preference shares 5, 000 Net worth applicable to equity 11, 000 Add : notional call on 60, 000 equity shares @Rs. 2. 5 per share 1, 50, 000 Adjusted net worth 12, 50, 000 Number of equity shares 1, 000 Value per share (fully paid) Value of equity shares on which Rs. 7. 50 paid 12. 50 -2. 50= 10

Yield Method Yield method Valuation based on rate of return Valuation based on productivity factor Valuation based on rate of dividend Valuation based on rate of earning

Valuation Based on Rate of Dividend • Suitable method for valuing small block of shares • Value of a share = paid up value of share * possible rate of dividend / normal rate of dividend • Example : if paid up value of a share is Rs. 80, normal rate of return 10% and past results show that company will pay dividend of 12% in future then value of a share = 80*12/10 = Rs. 96 Valuation Based on Rate of Dividend • Suitable for valuing large block of shares • Value of a share = paid up value * possible earning rate / normal earning rate • Example : if paid up value of share is Rs. 80, normal earning rate 16% and company’s past performance shows that it is expected to earn 20% in future then value of share = 80*20/16 = Rs. 100

Factors to be kept in mind while determining normal rate of return • • • Restrictions on transfer of shares : high restrictions = high NR and vice versa Disabilities attached to shares : more disabilities = high NR and vice versa Dividend performance : stable = low NR and vice versa Net asset backing : poor net asset backing = high NR and vice versa Financial prudence : sound financial policies = low NR and vice versa Valuation Based on Price Earning Ratio • Suitable for ascertaining market value of shares which are quoted on a recognised stock exchange • Value of share = earning per share * price earning ratio • Earning per share = profit available for equity shareholders / number of equity shares • Price earning ratio = market value of a share / earning per share

Valuation Based on Productivity Factor Productivity factor represents the earning power of the company in relation to the value of assets employed for such earning v Factor is applied to the net worth of the company on the valuation date to arrive at the projected earnings of the company v The projected earnings after necessary adjustments are multiplied by the appropriate capitalisation factor to arrive at value of the company’s business v The total value is divided by number of equity shares to ascertain value of each share v

Steps Involved in Valuation Based on Productivity Factor Average net worth of business is ascertained by taking those years whose results are relevant to the future � Net worth of the business on the valuation date is ascertained � Average profit earned for the period under consideration is ascertained � � Productivity factor is found out as : Average profit *100 Average net worth � Productivity factor is applied to net worth of the business on valuation date to ascertain the projected income of the business in future � Projected income is adjusted by making appropriations for replacement, tax, rehabilitation of plant & equipments, under-utilisation of productive capacity, effects of restrictions on monopoly and dividend on preference shares. Thus, profits available for equity shareholders are ascertained � The normal rate of return for the company is ascertained

CONTD. Appropriate capitalisation factor is ascertained � The capitalisation factor is applied to adjusted projected profits available for equity shareholders to ascertain capitalised value of undertaking � Value of share = capitalised value of undertaking / number of equity shares � Fair Value of Share � It is average of value obtained by net asset method and yield method

Example Diamond Ltd. Balance Sheet As on 30/6/2005 Liabilities Share capital (@100 each) Rs. 2, 000 Assets Rs. Land & buildings 1, 10, 000 1, 30, 000 General reserve 40, 000 Plant & machinery Profit & loss account 32, 000 Patents & trade marks 20, 000 Stock 48, 000 Debtors 88, 000 Bank balance 52, 000 Preliminary expenses 12, 000 Sundry creditors Income-tax 1, 28, 000 60, 000 4, 60, 000

�Assets were re valued at Land & building = Rs. 2, 40, 000 Goodwill = Rs. 1, 60, 000 Plant & machinery = Rs. 1, 20, 000 � Debtors of Rs. 8, 000 are found to be bad � Profits of the company have been as follows: 2003 - Rs. 80, 000 2004 - Rs. 90, 000 2005 - Rs. 1, 06, 000 � Company follows practice of transferring 25% of profits to general reserve � Similar type of companies earn at 10% of the value of their shares ascertain the value of the company’s shares under a) Intrinsic value method b) Yield value method c) Fair value method

Solution Intrinsic Value Method Assets : Land & buildings Goodwill Plant & machinery Patents & trade marks Stock Debtors less bad debts Bank balance Rs. 2, 40, 000 1, 60, 000 1, 20, 000 48, 000 80, 000 52, 000 7, 20, 000 Less : liabilities (sundry creditors) 1, 28, 000 Net assets 5, 92, 000 Value of shares = net assets/ no. of shares = 5, 92, 000/2000 = Rs. 296

Yield Value Method Rs. Total profit of last 3 years Less : bad debts 2, 76, 000 8, 000 2, 68, 000 Average profit = 2, 68, 000/3 Add : decrease in depreciation on plant & mach. (say @15% on 10, 000) Less : increase in depreciation on land & bldg. (say @10% on 1, 30, 000) 89, 333 1, 500 90, 833 13, 000 Average profit Less : Transfer to reserve (@25% 0 f Rs. 77, 833) 77, 833 19, 458 Profit available for dividend 58, 375 Rate of dividend = (58, 375 / 2, 000 ) * 100 = 29. 187% Yield value of share = (possible rate of dividend / normal rate of return) * paid up value of a share = ( 29. 187 / 10) *100 = Rs. 291. 87

Fair value method Fair value of a share = intrinsic value + yield value 2 = (296 +291. 87) / 2 = Rs. 293. 93 Valuation of preference shares 1. on dividend basis : used where there is adequate asset backing and company is a going concern = (paid up value * average maintainable dividend rate ) / normal rate of return 2. Net assets method : used when there is not adequate asset backing and company is going into liquidation

Example : a company has net assets of Rs. 1, 000 before payment to shareholders. Share capital consists of 5, 000 equity shares of Rs. 10 each and 2, 000 preference shares of Rs. 10 each. The preference shareholders are entitled to share 25% of surplus assets remaining after payment to the equity shareholders. Calculate the value of a preference share Solution : Net assets before payment to shareholders Less : preference share capital 1, 000 20, 000 Less : equity share capital 80, 000 50, 000 Surplus 30, 000 Share of preference shareholders in surplus Total net assets available for preference shareholders (20, 000 + 7, 500) Number of preference shares Value of preference share (27, 500 / 2000) 7, 500 2, 000 13. 75

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