Valuation of Shares- An overview
Valuation of shares is a method of determining intrinsic value of shares of a company. It is different from business valuation.
A business valuation is the process of determining economic value of company or business as a whole whereas valuation of shares is the system or process of knowing the value of a business by estimating the value of its shares.
Valuation of shares is done to evaluate the company’s net worth. There are different methods used for this purpose. In this article, we will discuss when a valuation of shares is required, how to do it and different methods of doing the same.
Situations where valuation of shares is required
Generally,share valuation is required in the following cases-
- In case a business firm is being overtaken by another business organization.
- In case a company is undergoing:
- In case a company is going to implement Employee Stock Option Plan (ESOP).
- In case a company wants to get loan wants to offer its shares as a security for obtaining the same.
- In case a company is planning to convert its preference shares into equity shares.
- At the time of issuance of shares by subsidiary to parent company or by Resident to Non Resident.
Different types of Share Valuation:
There are two types of share valuation on the basis of the methods used to derive the value of share. These are as follows-
- Absolute Valuation: In this the focus is only on the company’s fundamentals i.e. the cash flow, dividends and rate of growth of the business while calculating the price of the shares. Here, the intrinsic value of the shares is evaluated.
- Relative Valuation: It means when the ratio is analysed for ascertaining the stock value with other peer stocks or shares. One can use numerous ways to calculate value in this.
Methods used for Share Valuation:
Various methods can be used for valuation of shares of the company. These are as under:
- The Assets Approach: In this approach, the Net Asset Value (NAV) and equity shares of the company are used to calculate the shares value. The NAV is divided by the number of shares in the company to estimate the value of each of the share. To calculate the Net Asset Value one must find the difference between the organization’s assets and liabilities.
While calculating the share value through this approach, some must be kept in mind. These are-
- All the assets of the business are to be considered. This includes current liabilities like trade receivables, trade payables, provisions and more and current assets of the company. Further, intangibles like goodwill shall also be taken into consideration.
2. While eliminating, these must be kept in mind:
- Discount on issue of shares and debentures.
- Accumulated losses
- Preliminary expenses.
3. The reliable value of the fixed assets are to be considered.
The Income Approach:
In this approach, the future cash flow in the company and the expected benefits from the business investments are considered. Two popular method used under the income approach are-
- Discounted Cash Flow (DCF) method: In this method, we consider the future cash flow in the company for determining the share value with the help of the data available.
- Price Earning Capacity (PEC) Method: In this method, the history of the organization’s earnings and profits in the past are used to estimate the share value. If a company has not been in business for a very long time or has just started its business activities, then the PEC method cannot be used at all.
The Market Approach:
In this approach, the market value or market price of the shares are considered while evaluation. It is to be noted that this approach is advantageous only when the company is listed, for which a price for share can be obtained from the open market. Also, where there are other listed peer companies engaged in a similar business activity, then their market share prices can be used for the valuation of the share through a comparison method.
Factors affecting Share Valuation:
Valuation of Share is affected through various multiples which affect the evaluation system when one of the above methods is used. These primarily include the following-
- Net earnings and profits of the business.
- Dividends accrued.
- Cash flows of the business.
- Normal rate of return in the industry.
How to choose the best approach for Share Valuation?
One can use, any approach and method for share valuation. Each method has its own pros and cons and best method would depend upon the requirements of the person conducting the share valuation. Every business has its own characteristics, strengths and weaknesses and the rules for valuation changes from company to company. So, how to choose the best one. The answer is to consider all the available information the company for which the share valuation is to be done and the purpose behind it and then choose the most preferred option. As per the requirements and the objectives, the methods is to be applied for calculating the share value.