9 equity valuation

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EQUITY VALUATION

-Dr A.N.Garg

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VALUATION OF SHARES

Valuation Of Shares: In most of the cases, shares are quoted on

stock exchange; and for ordinary transactions in shares, the priceprevailing on the stock exchange may be taken as the propervalue. The stock exchange price does not hold good for very largelots. And not all shares are quoted on the stock exchange. Sharesof private companies in any case will not be quoted. If therefore,

shares of such a company have to change hands, the value ofsuch shares will have to be ascertained. In addition, in thefollowing circumstances, need arises for the valuation of shares:

1. For formulating a scheme of amalgamation.

2. For purchase and sale of controlling shares (stock exchange

quotations are valid only for regular lots.)3. For the valuation of assets of a finance or an investment trustcompany.

4. For security purposes, e.g. where loans are raised on thesecurity of shares.

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VALUATION OF SHARES5. Where a company is reconstructed under 494 of the Act and

there are dissentient shareholders.6. Where a company acquires the shares in a company under

Section 395 i.e. when 9/10ths of shareholders in a companyagree to transfer shares to another company and the transfereecompany decides to acquire the shares of dissentient

shareholders also.

Factors affecting Valuation of Shares:1. Purpose of valuation.

2. Nature of business.

3. Demand and supply of shares.4. Government policy.

5. Past performance of the company.

6. Growth prospects of the company.

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7. Management of the company.

8. Economic climate.

8. Accumulated reserves.9. Prospects of bonus/rights issue.

10. Declaration of dividends.

11. Other factors.


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VALUATION OF SHARES

VALUATION OF PREFERENCE SHARES:

When a company has to raise capital, it issues shares, which maybe equity or preference. It is worth mentioning here that beforethe enactment of Companies Act, 1956, there used to be

deferred shares also. A preference share is one on which the rate of dividend is fixed,

dividend is paid in priority to the owners of equity shareholdersand at the time of winding up these shares are repaid in priorityto the equity shares. These shares will be discussed in detail in

the chapter on Sources ofFunds. Here we will concentrate on itsvaluation part only.

Like bonds, it is easy it is not very difficult to estimate cash flowsassociated with preference shares. These cash flows may includeannual preference dividend and redemption value on maturity, incase the shares happen to be redeemable.

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VALUATION OF SHARES

The value of preference share would be the sum of the presentvalues of dividends and the redemption value. Suppose aninvestor is considering the purchase of a 12 year, 10%, Rs.100par value preference share, the redemption value being Rs. 120on maturity. The investor s required rate of return is 10.5%.

What should he be willing to pay for this share now? Theinvestor would expect to receive Rs. 10 as preference dividendeach year for 12 years and Rs.110 on maturity. We can use thepresent value annuity factor to value the constant stream ofpreference dividends and the present value factor to value theredemption payment.

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VALUATION OF SHARES

1 1 120

P0= 10*[-------------- - -----------------] + -------------

0.105 0.105*(1.105)12 (1.105)12

=10*6.506+ 120*0.302 = 65.06+36.24= Rs. 101.30It may be noted that the present value of Rs. 101.30 is a compositeof the present value of dividends, Rs. 65.06 and the present value ofthe redemption value, Rs. 36.24. The Rs. 100 preference share isworth Rs. 101.3 today at 10.5% required rate of return. The investor

would be better off by purchasing the share for Rs. 100 today.

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VALUATION OF SHARES

Valuation of Irredeemable Preference Shares:

Suppose a company has issued Rs. 100 irredeemable preference

shares on which it pays a dividend of 9%. Assume that this type

of preference share is currently yielding a dividend of 11%. The

preference dividend of Rs. 9 is perpetuity. The present value of a

preference share is:

PDIV 9

P0 = -------------- = -------- = Rs. 81.82

Kp 0.11

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VALUATION OF SHARES

Yield on Preference Shares: If the price of a preferenceshare is Rs. 81.82, What returns do investors require?

9

81.82= -------

Kp9

Kp= -------------- = 0.11 or 11%

81.82

The rate Kp is the preference shares yield-to-maturity.

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VALUATION OF SHARES Valuation of Equity/Ordinary Shares: Generally when we talk of

the valuation of shares, it refers to this category of sharesbecause the preference shares have a fixed rate of dividend andhardly there is any difference between the face value and itsmarket value.

In case of equity shares the rate of dividend is not fixed and thedeclaration and payment of dividend is also discretionary.

Because of the variability in the rate of dividend and uncertaintyof cash flows, it is somewhat more difficult to value this type ofshares as compared to the preference shares and of course,bonds.

The value of a share depends on cash inflows expected by the

investors and risk associated with those cash inflows. Cash flowsexpected from an equity share consists of dividends that theowner expects to receive while holding the shares and the price,which he expects to obtain when he sells that share. The price,which the owner is expected to receive when he sells the share,will comprise of the original investment plus a capital gain, or acapital loss as the case may be.

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VALUATION OF SHARES

Normally a shareholder does not hold the shares in perpetuity.He holds shares for sometime, receives the dividends and finally,sells them to obtain capital gains. The buyer is also purchasing astream of future dividends and a liquidating price when he alsoindulges in selling the shares. The expected cash flows consist

only of future dividends and, therefore, the value of an ordinaryshare is generally determined by capitalising the future dividendstream at the opportunity cost of capital. Opportunity cost ofcapital is the return that the shareholder could earn from aninvestment of equivalent risk in the market.

The value of a share is the present value of its future stream ofdividends.

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VALUATION OF SHARES Methods of Valuation:

1.Net Assets Basis/Intrinsic Value Method/Break-Up ValueMethod.

2. Earning Capacity/Yield Basis/Market Value Method.

3. Dual/Fair Value Method.

4. Other Methods.

1. Net assets Basis: This method is concerned with the assets backingper share and may be based either:

(a) On the view that the company is a going concern.

(b) On the fact that the company is being liquidated.

(a) Company as a going concern: In this context there are twoapproaches:

(i) To value the shares on the basis of net tangible assets.

(ii) To value the shares on the value of net tangible assets plus an

amount for goodwill.

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VALUATION OF BONDS--

(i) Net Tangible Assets Basis (Excluding Goodwill):In this case, the net tangible assets of the company are determined

and then the figure is divided by the number of equity shares. Non-

trading assets, like investments, are also included. Assets are taken

at the market value, if given. Otherwise they will be taken at the

book value. Amount due to preference shareholders is also

deducted along with other liabilities.

(ii) Net Assets Basis (Including Goodwill): In this case the amount

of goodwill will also be included in the value of net tangible assets

and then it will be divided by the number of equity shares to arrive

at the intrinsic value of the share.

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VALUATION OF SHARES

Assets Backing where a Company is being Liquidated:

Assets backing method is sound, in case liquidation iscontemplated. When liquidation/winding up looks imminent,it is desirable to prepare a statement of affairs, supported by

independent valuation of fixed assets such as land andbuilding, plant and machinery and goodwill etc. Provisionshould also be made for the costs of winding up and thus areasonable indication may be forthcoming for the payment tobe made to the members.

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VALUATION OF SHARES

Intrinsic value of shares is useful for formulating amalgamationschemes. Also if someone wants to acquire controlling shares

or if the company is about to go into liquidation, intrinsic value

is the price which is generally paid. This method of valuation is

suitable for a company which has been trading at a loss in the

past and there seem to be no prospects of earning any profit

in the near future. This method is considered to be acceptable

for statutory valuation, particularly the wealth tax rules

provide for assets basis of valuation of shares. However,

valuation on this basis may not be desirable in case of agrowing company. The practical difficulty may the in the

availability of the market value of assets, which may bring

subjectivity in valuation which in turn may deliver erroneous

results.

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VALUATION OF SHARES

2. Earning Capacity/Yield Basis/Market Value Method: In thismethod the shares may be valued in any of the following threeways:

(a) Valuation Based on Rate of Return.

(b) Valuation Based on P/E Ratio.(c) Valuation Based on Productivity Factor.

(a) Valuation Based on Rate Of Return: Rate of return heremeans the return which a shareholder earns on his investment.

RR can further be classified into:(i) Rate of Dividend.

(ii) Rate of Earning.

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VALUATION OF SHARES

(i) Valuation Based on Rate of Dividend:

Possible Rate of Dividend

Value of Share=------------------------------- X Paid up Value of share = Rs.

Normal Rate of Dividend

Dividend Per Share in Rs.

OR= -------------------------------- X 100 =Rs.

Normal Rate of Dividend

Total Profit available for dividend

Possible Rate of Dividend=------------------------------------------------X100

Total Paid-up Equity share capital

Dividend on equity shares is to be calculated after providingfor taxation, transfer to reserves, transfer to sinking fund forredemption of debentures and preference dividend etc.

This method of valuation is suitable for small block of sharesas small shareholders are invariably interested in dividends.

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VALUATION OF SHARES

(ii) Valuation Based on Rate of Earnings:Possible Rate of Earning

Value of Share=-------------------------------- X paid-up value of share

Normal Rate of Earning

Actual Profit Earned

Rate of Earning= ---------------------------------X100

Capital Employed

In total capital employed, we have to include long term borrowings also.Profit has to be considered before interest on long term borrowings and

preference dividend but after tax.This method is particularly suitable in case of big investors as they aremore interested in earnings than the rate of dividends.

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VALUATION OF SHARES(b) Valuation Based on P/E Ratio: Another method of valuing shares isbased on EPS * P/E ratio. The P/E ratio is really the converse of thenormal rate of return. If normal rate of return is say 20%, it means theP/E ratio will be 5. If the EPS is Rs. 7 , the price of share will be Rs. 35.The P/E ratio is high where risk is low and vice versa.

Profit available for equity shareholders

Earning Per Share=------------------------------------------------------ = Rs.

No. of Equity SharesMarket Price Per Share

Price Earning Ratio = -------------------------------------

Earning Per Share

100

OR = --------------------------------------------

Normal Rate of Return

This method is more suitable for ascertaining the market value of shareswhich are quoted in a recognised stock exchange.

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VALUATION OF SHARES

Sometimes P/E ratio may mislead about the performance of ashare. As already indicated, a high P/E ratio is consideredgood but it is worth mentioning here that the ratio may behigh not because the share price is high but may be because

of quite low earnings per share. Further, the interpretation ofP/E ratio may become meaningless because of themeasurement problems of EPS. A number of arbitraryassumptions and choices is then made to estimate theearnings. Accounting policies may be manipulated and altered

which may distort the fair estimation of earnings. Non cashitems such as depreciation may be included in the earnings.Thus, it may be difficult to interpret EPS meaningfully and relyon EPS and P/E ratio as the measure of performance,particularly in the context of share valuation.

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VALUATION OF SHARES

(c) Valuation Based on Productivity Factor: Productivity factormeans the earnings power of the company in relation to the networth of the company.

Average Weighted Taxed Profit

Productivity Factor =------------------------------------------------ X 100Average Weighted Net Worth

Average weighted tax profit and average weighted net worth areascertained by taking a number of years whose results are relevant

for the future.

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VALUATION OF SHARES-- Productivity factor is applied to the average weighted net worth of the

company on the valuation date of shares to arrive at the maintainableprofits. These profits after necessary adjustments, if any, such asdividend on preference shares, effect of under- utilisation of productivecapacity, making appropriation for rehabilitation and replacementpurposes, are divided by the normal rate of return to arrive at the valueof the companys business in relation to its equity shareholders. Thevalue of companys business so obtained is divided by the number ofequity shares to get the value of each equity share.

The safest value that can be put on the equity shares is that on the basisof earnings ratio---- the other two values having some unnaturalelements. Intrinsic value looks to be irrelevant, since those invest in

shares do not have much interest in the assets representing the share;they are rather interested in the income. The market value based on themaximum possible dividend may also not hold good since very fewcompanies will distribute whole of the profit earned by them. Hence,the value based on earnings ratio seems to be the most plausible one.

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VALUATION OF SHARES--

Single Period Valuation: Let us assume that an

investor intends to buy a share and will hold it for

one year. He expects the share to pay a dividend

of Rs. 2 next year, and would sell the share at anexpected price of Rs. 21 at the end of the year. If

the investors opportunity cost of capital/RR (Ke)

is 15%, how much he should pay for the share

today.

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VALUATION OF SHARESThe present value of the share today, P0, will be determined as thepresent value of the expected dividend per share at the end of the firstyear, DIV1, plus the present value of the expected price of the shareafter a year, P1.

DIV1+P1

P0 =------------------

1+Ke2+21

P0= -----------------= Rs.20

1.15

We can say that it gives us the fair or reasonable price of the share,since it reflects the present value of the share. The investor would be

interested in buying the share if the actual price were less than Rs. 20. Ina well functioning capital market, there ought not to be any differencebetween the present value and the market value of a share. Investorswould have full information and it would be reflected in the market priceof the share in a well functioning market.

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VALUATION OF SHARES--

In practice, there could be a difference between the presentvalue and the market value of a share. An under valued sharehas a market price less than the present value of the share. Onthe other hand, an over valued share has a market price higherthan the present value of the share.

The share value after an year represents an expected growth orcapital gain.

21-20

g= ------------ = 0.05 or 5%

20

P1-P0g=-------------

P0

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VALUATION OF SHARES

An investor can represent his expectation with regard to the future

share price in terms of expected growth. In nutshell, the presentvalue of a share is determined by its expected dividend divided bythe difference of the shareholders capitalization, or required rate ofreturn (Ke) and growth rate (g). If the investor would have expectedthe share price to grow at 5%, the value of the share today will be:

DIV1P0 = ------------------

Ke - g

2 2

P0

= --------------- = -------------- =Rs.20.

0.15- 0.05 0.10

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VALUATION OF SHARESMulti Period Valuation: Now we have to understand the rationale for thenew investor to purchase the share at the end of one year. He also expectsa stream of dividends during the period he holds the share plus liquidatingprice of the share. The price next year (P1) will depend on expecteddividend in year 2 and expected price of the share at the end of year 2. Ifwe consider that DIV2= Rs. 2.10 and P2=22.05, then P1 is:

2.10+22.05

P1 =-------------------- = Rs. 21.1.15

Todays price (P0) can be calculated as the discounted value of dividendsin years 1 and 2 and liquidating price at the end of year 2 as follows:

2 2.10+ 22.05

P0 = -------+ -------------------- = Rs. 20.1.15 (1.15)2

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VALUATION OF SHARES

Value of Share under Constant Growth: Suppose that the price of

share today(P0) is Rs. 20 and it is expected to increase at an annualrate of 5% Assume that the expected dividend after a year (DIV1) isRs. 2 and it is also expected to grow at the rate of 5% p.a. if theopportunity cost of capital is 15% what would be the price of theshare if it were held for 5 years?

2.00 2.10 2.21 2.32 2.43 25.53P0 = {------+-------+------+-------+ --------- } + ------------

(1.15) (1.15)2(1.15)3 (1.15)4 (1.15)5 (1.15)5

= 7.31+ 12.69 = Rs.20.

The present value of stream of dividends is Rs. 7.31 and of the shareprice at the end of five years is Rs. 12.69, the total present value ofthe share being Rs.20.

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VALUATION OF SHARES

Growth in Dividends: Dividend on equity shares, invariably,does not remain to be constant. Earnings of most of thecompanies grow with the passage of time and thereforegenerally there is an increase in the rate of dividends too. Manycompanies, in spite of having increased earnings, believe in

maintaining the rate of dividend. Almost all the companies tryto transfer a part their profit to reserves for the purpose of theirfuture needs, may be to face rainy days, expansion,modernisation and diversification etc. This leads to theenhancement of owners equity as well as firms future earnings.

If the number of shares does not change, this policy should tendto increase EPS, and, consequently, it should produce anexpanding stream of dividends per share.

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VALUATION OF SHARES

Normal Growth: If a totally financed firm retains a constant

proportion of its annual earnings (say b) and reinvests it at its internalrate of return, which is its return on equity (say, ROE), then it can beshown that the dividends will grow at a constant rate equal to theproduct of retention ratio and return on equity; that is, g=b X ROE.

DIV2-DIV1

Growth in dividends=--------------------DIV1

Growth will be more if the firm retains higher proportion of earnings.The current dividend will, however, be reduced, which may beresented by the shareholders who have acquired the shares for a

short period of time. In the best interests of the company and longterm shareholders a share valuation model should explicitly involvegrowth expectations.

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VALUATION OF SHARES

Super- Normal Growth: The dividends of a company may notgrow at the same constant rate indefinitely. It may face a two-

stage growth situation. In the first stage, the dividends may

grow at a super-normal growth rate, when the company is

experiencing very heavy demand for its products and is able to

extract premium from customers. Afterwards, the demand forthe companys products may normalise and therefore, earnings

and dividends may grow at a normal growth rate.

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9 equity valuation

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