This blog is written by Mr. Ahmed Yar Khan, Senior Manager Audit and Assurance Services. Please read this blog and provide your valued comments
Valuation of shares is the process of determining the fair value of the company shares. Share valuation is done based on quantitative techniques and share value will vary depending on the market demand and supply. The share price of the listed companies which are traded publicly can be known easily. But with respect to private companies whose shares are not publicly traded, valuation of shares is really important and challenging.
Share Valuation Approaches and Methods
There are various reasons for adopting a particular method for share valuation; it generally depends upon the purpose of valuation. Using a combination of methods generally provides a more reliable valuation.
- Net Assets Method
Value of the entity is considered to be the liquidating/realizable value of its net tangible assets. Intangible assets including goodwill are excluded, unless they have a market value.
Valuation of shares is calculated by subtracting any liabilities from the market value of the entity’s assets and dividing the difference by the number of shares outstanding. This method illustrates the amount a shareholder would receive for each share owned if the entity sells all its assets at their current market value, pays off any outstanding debts with the proceeds, and then distribute the remainder to the stockholders.
The method is used as benchmark when an organisation is not operating to desired level of efficiency and it is considered that assets are disposed off to another entity which may have a better use of such assets. The method is often thought to be a good basis to acquire an entity with valuable tangible assets, especially, freehold property which might be expected to increase in value over time.
This valuation method suffers from the difficulty of establishing the asset values to use. The value of an individual asset may vary considerably depending upon whether it is valued at break-up value or on forced sale basis. The method also does not take into account the past and future rate return on the equity which is an important factor in valuation of business entities as the prime objective of all business entities is to make profit.
- Discounted Cash-flows Method
Valuation of net worth of a business entity /shares on the basis of discounted future cash flows (net present value concept) is one of the methods which is commonly used. The concept of discounted cash flow technique is that an investor spends money today in order to receive a stream of net cash inflows over a period of time in future. The present value of net worth of the entity is arrived by discounting the future cash flows at its Equity Capitalization Rate i.e. the required rate of return based on the risk involved.
This method of valuation is appropriate when an entity intends to buy the assets of another entity and make further investment in order to improve cash flows in future. The short comings of this method is the business risk of the new investment may not match that of the investing entity which would may have different equity capitalization rate than that of the new project due to variation in the business risk of the existing business and of the new entity being acquired. Secondly, the mode of financing of new investment may not match the current financing structure (debt/equity mix of the investing entity) which may have an effect on the equity capitalization rate to be used.
- Discounted Free Cash-flows Method
The present value of future cash flows model focuses on the strategic needs of companies to reinvest in new plant to maintain or increase current operating cash flows. New capital expenditure is generally not equal to the depreciation charge for the year. Free cash flow takes into account this difference. Free cash flow is equal to cash flow generated from operating activities less debt repayments, lease payments and replacement of capital expenditure. The value of an entity is equal to the sum of discounted future free cash flows.
The advantage of including strategic value as well as existing project value in determining the value of the entity is that strategic value can often be of be a significant element of entity’s value. Free cash flow is also used in deciding dividend payout ratio. The drawback is the same as with other methods valuation based on discounted cash flows i.e., the accuracy of future projection and use of appropriate discount factor.
- Gross Revenue / Earnings Method
This method determines the value of entity on the basis of relationship of current shares price to the annual sales per share. In other words, it tells as to how much the share costs per Rupee of sales earned. To compute it, take the current share price quoted on stock exchange and divide it by the annual sales per share. This ratio measures the total company value as compared to its annual sales. A high ratio means that the company’s value is much more than its sales. To compute it, divide the market value of the equity of the company (market capitalization) by the sales for the last four quarters.
This method is especially useful when valuing companies that do not have earnings, or that are going through unusually rough times. For example, if a company is facing restructuring and it is currently losing money, then the P/E ratio would be irrelevant. However, by applying “market value to sales ratio”, it can be computed as to at what price the shares of the company could trade for when its restructuring is over and its earnings are back to normal.
- Earnings Capitalization Method
A common method of valuing a business is called Earnings Capitalization (or Capitalized Earnings) method. Capitalization refers to the return on investment that is expected by an investor.
This method of valuation is based on concept that an asset is valued on the basis of its earnings capability. An asset which provides higher rate of return than required is valued proportionately at a higher price and an asset which earns less than required rate of return is, accordingly, valued at a lower price. Consequently, shares of the companies which have higher rate of return than required are quoted at stock exchange at a price higher than their face value and the shares of the companies having lower rate of return lower than required are quoted at prices lower than their face value.
In earning based valuation two factors are pivotal i.e., earning per share (return on equity) and required rate of return on the equity. Since shares are acquired on consideration of their future expected earnings, it is always preferred that future estimated profits should be the basis for valuation instead of past profits. The second factor is the required rate of return on equity commonly known as Equity Capitalization Rate. Equity capitalization rate could either be the return on equity offered by the entities in the relevant business sector or calculated by using Capital Assets Pricing Model (CAPM). The latter basis is considered better as it takes into consideration the relative risk of the entity with risk assumed by the entity relative to other business organizations in the market.
The value is assessed by using required rate of return that an investor would expect on particular type of investment and then divide the expected annual earnings with required rate of return. Equity capitalization rate is inversely the price-earnings ratio a popular stock market ratio. Valuation under this method is preferably based on normalized earnings reflecting its future operating performance. The capitalization of earnings valuation method is a method within the income approach to value whereby representative annual economic benefits are converted to value through division by a capitalization rate. The valuation concept is that a company’s value is established primarily by the income it can be expected to earn on an ongoing basis, in relationship to a capitalization rate measuring rate of return, investment risk and potential earnings growth.
Valuation under this method involves not only forecast of future earnings but also the expected change in the price earnings ratio of the relevant sector of industry as well as of overall financial market which involves many unknown. Nevertheless, this method of valuation is commonly used for short period valuation of shares. Degree of accuracy of valuation under this method depends upon the accuracy of the estimates of future profit and the ability of the entity to maintain it relative market risk in future.
The advantage of this method of valuation is that it is based on the concept of ‘’Risk and Return’’ and also takes into consideration the operating performance of an organization and is , thus, considered to be the most appropriate basis for valuation of net worth of an organization.
- Super Profit Approach
The method is based on the concept that an entity is earning higher return than required on its net tangible assets on going concern basis. Any excess of profit over required is considered super profit which is expected to continue for some future period and is used to calculate Goodwill. The goodwill is normally taken as a fixed number years of super profit. The goodwill is then added to the value of its tangible assets to arrive at the value of net worth of an entity.
The merit of the system is that it does take into consideration efficiency of operating performance of the entity in valuation in addition to the value of net tangible assets. The principal drawback of the system is that number of years’ purchase of super profit is arbitrary.
- Quoted Price/Price of last Sale or Purchase Transaction
In case a company is listed on stock exchange, the quoted price fairly reflect value of its equity and is used as a benchmark of sale and purchase of entity shareholdings. In case of unlisted company, the latest sale and purchase prices of shares of the company based on free arm length transactions provides a reasonable basis for valuation of entities shareholdings.
This valuation method provides a fairly reasonable basis for valuation of shares subject to the consideration that latest transactions are free arm length deal and not under coercion or for other considerations.
Ahmed Yar Khan
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