Before buying shares of any company what’s the first thing a person do? Trying to know the valuation of shares of the company, I guess. Isn’t it?
But the value of shares of every company isn’t available so easily in the public and if the company is not listed in any stock exchange yet then to know it’s valuation is even more difficult.
In this article, we will discuss how valuation of shares of each company is derived and what are the methods to deriving the value of each share of a company.
Valuation of Shares
It’s the process of evaluating the fair market value of the share of a particular company.
Not all companies are listed in public stock exchange market and those which are listed, not all of them are public company. Some of them are private also.
Share of Public companies which are listed on stock exchange are easily available for public view.
In case , a person or group of person wants to know the value of a share of any company, they can know about it only through some mathematical calculations. There are quantitative techniques available in the market to determine the valuation of shares of a company.
There are many companies whether public or private, which are not listed in the stock markets, yet they need to determine the value of shares of their company for several reasons.
There are many reasons for which valuation of share is important and is explained in detail further in the article.
But before discussing the importance of valuation of shares, let us first discuss what are methods of determining the value of a share and which one is best suited for you.
Methods of valuation of share
As far as methods of share valuation are concerned, there are many methods to do the calculation. They are –
- Net asset value or Intrinsic value method
- Profit based or Dividend Yield method
- DCF Method (Discounted Cash Flow)
- PE Ratio Method (Price-Earnings Ratio)
Apart from these, there are other methods also but they are not so popular among companies so we will not consider them in this article. Our main focus will be on those mentioned above.
Each of the method is explained below in detail and along with that, their suitability for a company is also explained but that should be taken with a pinch of salt as suitability of a formulae can best be advised by experts and for that you can contact experts at Company Vakil. In this article, however, we have discussed the topic in a general sense.
One thing to note here is that, suitability of a method for valuation of shares depends upon nature, volume, size and profits of the company and along with that purpose and data availability is also necessary for choosing the right method.
Below are methods and their suitability.
1. Net asset value based
This method is also known as Intrinsic value method. Under this, net asset of the company is taken as a base to calculate the value of each share.
Net asset of the company is derived by excluding the preference shares from the total assets of the company. Here, total assets of the company include all the capital and non-capital assets such as intangible assets.
While determining the net asset value of the company, external liabilities are also considered. Liabilities are not an asset for the company. So these are excluded from total assets to determine the net assets. However, contingent liability is an exception in this regard.
Contingent liability forms the part of assets of the company as they presently do not form any liability on the company.
All the capital and non-capital assets are calculated at the present market value. Intangible assets are a bit difficult to determine as they do not have any physical form. But they are determined similarly to the goodwill valuation of the company. However, goodwill value of the company itself form the part of intangible assets.
(Net Assets = Total assets of the company – Preference Shares – External Liabilities)
Once the net asset of the company is available and total equity shares are known then the value of each share can be derived by dividing Net assets of the company by total no of equity shares.
(Value of each share = Net assets of the company / Total number of Equity share )
All the data for calculation should be taken from last audited balance sheet of the company.
For better understanding, an illustration is given below –
For a company ABC,
|Items||Amount (In Rupees)|
|Items||Amount (In Rupees)|
|Preference Share Capital||50,000|
|Items||Amount (In Rupees)|
|Total assets (Table A)||2,50,000|
|Liabilities + Preference Share Capital (Table B)||-1,00,000|
|Net Assets (Table A – Table B)||1,50,000|
|Total no of Equity Share (Assume)||÷ 1,000|
|Value of one share =||Rs 150|
So here, we have determined the valuation of shares of company ABC. The value of one share of a company ABC is Rs 150 as determined in above illustration.
This method is best suitable for capital intensive companies such as manufacturers, distributors etc. Because of large amount of assets created already , it becomes easy for them to adopt this method to calculate valuation of shares. Investment companies also use this method to evaluate valuation of their shares.
This method is also useful for those companies who has future plans of investing high in capital asset formation.
On the other hand, this method is also, sometimes, used for cross examining the valuation of shares already calculated using other methods.
2. Profit based or DYM
Under this method, profit or dividend of the company is used as a base for calculation of valuation of shares. Total average profit of at least 5 years or dividend after tax is taken and same is divided by normal rate of return to determine capitalised value.
Here, profit is calculated by taking into account last 5 years of company’s profits which should be audited ones.
Tax and preference share capital are excluded from the profits for the purpose of valuation.
This capitalised value is further divided by total number of shares to evaluate the value of one share.
For simplification, profit or dividend is taken as a base because, like capital assets, profits and enough dividend show the healthiness of the company, hence can be treated as assets itself. But technically it is different from assets thereby method is also different.
Companies having a history of earning profits in recent years i.e. at least 5 years uses this method to calculate the value of their shares.
This method is not so preferable by companies and those who uses this method, again cross-examine the value by calculating other methods like net asset value one.
3. DCF Method (Discounted Cash Flow)
This method is mainly popular with dynamic companies or start-up companies. Calculation under this method is a bit complex one and so is understanding it. But it is simplified herein for better understanding.
This method uses not only the present health of the company but also considers future prospects of the company. This is one of the reason, this method is considered by many as one of the best one to determine the fair value of the shares of the company.
While evaluating the valuation of shares, this method takes into consideration future capital inflows in the company either in cash or assets and expected rate of return of equity and debt holders.
Formulae for calculation of value of share under DCF Method is below –
|DCF = CF/(1+r)¹ + CF/(1+r)²+……+ CF/(1+r)^n|
Here, DCF = Discounted Cash Flow
CF = Cash Flow ( It is the regular flow of cash to investors who has invested in the company through securities or bonds).
r = discount rate ( It signifies required rate of return to the probable investors who expects this return after investing).
n = time period ( Cash flow to the investors is done according to time period. For eg: – monthly, quarterly or yearly).
To simplify the complexities, whole process is explained below in points: –
- As this method takes into consideration future earnings or profits, so the first step is to derive projected profits.
- Projected profits should be calculated after tax i.e. tax needs to be deducted from total profits.
- After that, add depreciation value of non-cash costs in the projected profits.
- Exclude or subtract increase in working capital and capital expenditures.
- Adjust changes in debts.
- Discount free cash flow of firm for every year till the last one at the cost of the capital.
- Then again add terminal value that arises in the final year of the total period.
- Now subtract debt value to derive net equity value.
- Divide the net equity value by total number of shares.
- And value of one share is derived thereby.
This method is best suitable for start-up companies who’s present status has nothing to show much but future prospects looks bright given the impressive ideas behind the company.
Other companies whose present health is not so okay but is expected to make a good profits in future due to certain policy changes. Then also they use this method.
As this method also includes expectation of owners and lenders by taking into consideration expected rate of return from equity and debt securities or bond holders, the valuation derived thereby is highly dynamic in nature.
4. Price-Earnings Ratio method
Under this method, at first Price-Earnings ratio is derived and then taking that as base, value of each share is calculated.
Price-Earnings Ratio is derived by dividing Market Per Share (MPS) by Earning Per Share (EPS) i.e. –
|PE Ratio = MPS/EPS|
Once PE Ratio is derived, value of each share can easily be calculated. For that, EPS i.e. Earnings Per Share is multiplied with PE Ratio.
|Value of one share = EPS × PE Ratio|
Mainly companies listed on stock markets uses this method to derive value of their shares. When the company declares it’s quarterly or monthly results, then investors uses this method to derive the value of the shares so that they can make good investment decisions.
Why valuation of shares is required?
There are many reasons for which companies or investors are required to determine the value of shares of a particular company. Some of them are –
- When a company proceed for amalgamation.
- Or when they involve in Mergers and Acquisition then also valuation of shares is required.
- Many start-up companies when look for investment capital, has to first evaluate value of their company so that they can sell their shares to possible investors.
- Investors of listed companies also uses these methods to calculate the value of their shares so as to make the right investment decisions.
- Many private companies do not disclose the value of their shares, so when some one is interested in knowing their share’s value, they can use these methods.
- When approaching to banks for loan then also it is required.
- When preference shares are converted into equity ones.
- If involved in some litigation which requires to disclose the value of company’s shares.
- At the time of nationalisation of any company, then to compensate their shareholders, valuation of shares are required.
- While implementing Employee Stock Ownership Plan (ESOP).
- For tax assessments purposes. For more details visit Company Vakil