Valuation of Shares

 

Meaning of Valuation of Shares 

The valuation of shares refers to the process of determining the worth or value of a company’s stock. This involves estimating how much a share should be worth based on various factors and methodologies. The goal is to provide an objective measure that can help investors, analysts, and corporate managers make informed decisions.

 Valuation of shares of a company is not an easy task. A number of factors are associated with it. All such factors may not be taken into account for ascertaining the exact value of shares. For example, if the shares of a company are not quoted on the stock exchange, their value cannot be determined precisely. Some shares, especially private company shares possesses no market value as their transferability is restricted.

Definitions of Valuation of Shares by different authors

Here are definitions of the valuation of shares from various authors and sources:

1. Aswath Damodaran:

In his work on valuation, Damodaran defines the valuation of shares as the process of estimating the value of equity based on the expected future cash flows and risk associated with those cash flows. This involves discounting projected cash flows to their present value using an appropriate discount rate.

2. Paul A. Samuelson:

Samuelson, in his contributions to financial theory, describes the valuation of shares as the determination of the present value of a company’s future earnings or dividends, adjusted for risk and time. This valuation helps investors decide on the worth of shares in the context of market efficiency.

3. Michael C. Jensen and William H. Meckling:

Jensen and Meckling, in their study of agency theory, refer to the valuation of shares as the process of determining the price of a company’s stock based on its financial performance and governance structure. This valuation plays a crucial role in aligning the interests of management and shareholders.

4. Frank J. Fabozzi and Pamela Peterson Drake:

Fabozzi and Drake define the valuation of shares as the technique used to estimate the worth of equity in a company by applying various financial models, including discounted cash flow (DCF), price multiples, and asset-based approaches. This process helps in assessing investment opportunities and making strategic decisions.

5.  Oxford English Dictionary:

 The valuation of shares refers to the assessment of the worth or price of a company’s stock, usually conducted by analyzing various financial metrics, market conditions, and valuation models to determine its fair market value.

These definitions reflect various approaches and perspectives on share valuation, highlighting its importance in investment analysis, financial reporting, and corporate decision-making.

Need for valuation of shares

Valuation of shares is a crucial process in finance and investment for several reasons. Here’s an overview of why it’s necessary:

1. Investment Decisions

Investors need to determine whether a share is overvalued, undervalued, or fairly priced. Valuation helps in making informed decisions about buying, holding, or selling shares. It also allows investors to compare the value of different shares and choose the most promising investment opportunities.

2. Corporate Actions

Accurate valuation is essential for negotiating fair prices in mergers, acquisitions, or takeovers. Both acquiring and target companies use share valuation to agree on transaction terms.

3. Financial Reporting

Companies need to value shares for financial statements and disclosures. This includes reporting the value of shares held in treasury or stock-based compensation for employees.  Accurate valuation is necessary to comply with regulatory requirements and accounting standards.

4. Strategic Planning

 Share valuation helps in assessing a company’s performance and making strategic decisions based on its market value. Understanding the value of shares helps in managing financial risk and making adjustments to investment portfolios.

5. Estate Planning and Taxation

Valuation is needed to determine the value of shares for estate planning, inheritance purposes, and tax calculations. It helps in calculating capital gains or losses for tax reporting when shares are sold.

6. Shareholder Disputes

In cases of disputes among shareholders, such as buyouts or legal conflicts, accurate valuation is crucial for fair resolution.

7. Corporate Governance

Valuation can be used to assess executive performance and align incentives with shareholder value. Companies may use share valuation to determine appropriate dividend payouts.

Methods for Valuation of Shares

There is no one valuation method that will fit any purpose, hence there are various methods of share valuation depending upon the purpose, data availability, nature and volume of the company etc. Valuation of shares can be approached through various methods, which generally fall into three main categories:

1. Asset-Based,

2. Income-Based, and

3. Market-Based methods.

Each category provides a different perspective on a company’s value and is suited to different types of businesses and valuation purposes. Here’s an overview of each method:

1. Asset-Based Valuation

Asset-based valuation of shares involves determining the value of a company’s equity by assessing its net assets—total assets minus total liabilities. This approach focuses on the company’s balance sheet rather than its earnings or market performance. It is particularly useful for companies with significant tangible assets or in situations of financial distress.

Key Methods of Asset-Based Valuation

i. Book Value

The book value of a company’s shares is calculated using the company’s balance sheet. It represents the net asset value of the company as recorded in its financial statements.

Formula:

Book Value = Total Assets − Total Liabilities

Example:

• Total Assets: ₹800 crore
• Total Liabilities: ₹500 crore

Book Value=₹800 crore−₹500 crore=₹300 crore

If there are 10 crore shares outstanding:

Book Value per Share= ₹300 crore / 10 crore shares =₹30 per share

 

ii. Adjusted Book Value

Adjusted book value modifies the book value to reflect the current market value of assets and liabilities. It involves revaluating assets and liabilities to their fair market values.

Formula:

Adjusted Book Value = Adjusted Total Assets − Adjusted Total Liabilities

Example:

Original Book Value of Property: ₹100 crore

Market Value of Property: ₹150 crore

Original Book Value of Equipment: ₹50 crore

Market Value of Equipment: ₹45 crore

Original Book Value of Inventory: ₹30 crore

Market Value of Inventory: ₹28 crore

Total Liabilities: ₹200 crore

Adjusted Total Assets =₹150 crore (property) + ₹45 crore (equipment) + ₹28 crore (inventory) = ₹223 crore

Adjusted Book Value = ₹223 crore − ₹200 crore = ₹23 crore

If there are 5 crore shares outstanding:

Adjusted Book Value per Share = ₹23 crore​ /  5 crore shares =₹4.60 per share

iii. Liquidation Value

Liquidation value estimates the amount that could be realized if a company’s assets were sold off individually and its liabilities settled. This method is often used in insolvency situations.

Formula:

Liquidation Value = Realizable Value of Assets − Settlement of Liabilities

Example:

• Realizable Value of Assets (after discounts): ₹350 crore
• Total Liabilities: ₹250 crore

Liquidation Value =₹350 crore−₹250 crore=₹100 crore

If there are 10 crore shares outstanding:

Liquidation Value per Share  =₹100 crore / 10 crore shares = ₹10 per share

 

Practical Application

Asset-Based Valuation in Practice:

i. Real Estate Companies:

For companies primarily involved in real estate, such as real estate investment trusts (REITs), asset-based valuation is often crucial. The value of the company’s properties (real estate assets) directly impacts its overall valuation.

ii. Distressed Companies:

In cases where a company is financially distressed or facing bankruptcy, liquidation value provides a conservative estimate of the company’s worth based on how much can be recovered from asset sales.

iii. Manufacturing Companies:

Companies with substantial tangible assets like machinery, equipment, and inventory often use asset-based valuation to determine their worth, particularly if they have significant physical assets relative to their income.

 

2. Income-Based Valuation

Income-based valuation of shares focuses on determining a company’s value based on its ability to generate future income or cash flows. This approach is grounded in the principle that a company’s value is fundamentally linked to its earning potential. The main methods of income-based valuation include Discounted Cash Flow (DCF) analysis, Dividend Discount Model (DDM), and Earnings Valuation.

Key Methods of Income-Based Valuation

i. Discounted Cash Flow (DCF) Analysis

DCF analysis estimates the value of a company based on the present value of its projected future cash flows, discounted at a rate that reflects the risk of those cash flows.

Formula:

Value= CF₁ /(1+r)¹       + CF₂ /(1+r)² +…+CF_n /(1+r)ⁿ         

^{where CF = Cash Flow, r = Discount Rate, and n = Number of periods.}

^Example:

^{Projected Cash Flows:}

• ^{Year 1: ₹50 crore}
• Year 2: ₹55 crore
• Year 3: ₹60 crore

^{Discount Rate: 10%}

Calculation:

Value = ₹50 crore /(1+0.10)¹       +  ₹55 crore/(1+0.10)²  + ₹60 crore /(1+0.10)³         

Value= ₹50 / 1.10 + ₹55 / 1.21 + ₹60 / 1.331

Value=₹45.45 crore+₹45.45 crore+₹45.15 crore=₹136.05 crore

If there are 10 crore shares outstanding:

DCF Value per Share=₹136.05 crore / 10 crore shares=₹13.61 per share

 

ii. Dividend Discount Model (DDM)

The Dividend Discount Model values a company based on the present value of its expected future dividends. This method is suitable for companies that pay regular dividends.

Formula:

Value= D₀​(1+g)​ / r−g

where D₀​ = Current Dividend, g = Growth Rate of Dividends, r = Required Rate of Return.

Example:

• Current Dividend (D0): ₹6 per share
• Growth Rate (g): 4% or 0.04
• Required Rate of Return (r): 9% or 0.09

Calculation:

Value= ₹6×(1+0.04) / 0.09 – 0.04

Value= ₹6.24 / 0.05 =₹124.80 per share

 

iii. Earnings Valuation

Earnings valuation determines a company’s value by applying a multiple to its earnings. The most common multiple is the Price-to-Earnings (P/E) ratio.

Formula:

Value=Earnings×P/E Ratio

Example:

• Earnings Per Share (EPS): ₹20
• P/E Ratio: 15

Calculation:

Value=₹20×15=₹300 per share

Practical Application

Income-Based Valuation in Practice:

i. Growth Companies:

For companies with high growth potential but lower current earnings, such as tech startups, DCF and DDM methods are particularly useful as they focus on future cash flows and dividends rather than current profitability.

ii. Dividend-Paying Companies:

Established companies that have a stable dividend payout, such as utility companies, are often valued using the DDM method, which focuses on the present value of future dividends.

iii. Stable Profitability:

Companies with stable and predictable earnings, like mature consumer goods firms, are often valued using the P/E ratio, which reflects current earnings and provides a quick estimate of value relative to earnings.

3. Market Based Valuation

Market-based valuation of shares involves determining a company’s value based on the prices of similar companies or market data. This approach relies on comparing a company to others in the same industry or using current market prices and multiples. It’s often used to gauge a company’s value relative to its peers or historical performance. The primary methods in market-based valuation include Comparable Company Analysis (Comps), Precedent Transactions Analysis, and Market Capitalization.

Key Methods of Market-Based Valuation

i. Comparable Company Analysis (Comps)

Comps valuation involves comparing the company to similar companies in the same industry to derive a value based on relevant financial multiples.

Common Multiples Used:

• Price-to-Earnings (P/E) Ratio
• Enterprise Value-to-EBITDA (EV/EBITDA) Ratio
• Price-to-Book (P/B) Ratio

Formula:

Value = Multiple × Comparable Metric

Example:

• Metric Used: EBITDA
• EBITDA of Company: ₹70 crore
• Average EV/EBITDA Multiple for Comparable Companies: 8

Calculation:

Value = ₹70 crore × 8 = ₹560 crore

If there are 10 crore shares outstanding:

Comps Value per Share= ₹560 crore / 10 crore shares = ₹56 per share

 

ii. Precedent Transactions Analysis

This method values a company based on the multiples paid in recent transactions involving similar companies. It’s often used to gauge how much acquirers have paid for similar businesses.

Common Multiples Used:

• Price-to-Earnings (P/E) Ratio
• Enterprise Value-to-Sales (EV/Sales) Ratio

Formula:

Value = Transaction Multiple × Target Metric

Example:

• Metric Used: Revenue
• Revenue of Company: ₹120 crore
• Average Revenue Multiple from Recent Transactions: 3.5

Calculation:

Value = ₹120 crore × 3.5 = ₹420 crore

If there are 10 crore shares outstanding:

Precedent Transactions Value per Share= ₹420 crore / 10 crore shares =₹42 per share

 

iii. Market Capitalization

Market capitalization is the total value of a company’s outstanding shares of stock. It’s calculated by multiplying the current share price by the total number of outstanding shares.

Formula:

Market Capitalization=Share Price×Number of Shares Outstanding

Example:

• Share Price: ₹75
• Number of Shares Outstanding: 15 crore

Calculation:

Market Capitalization = ₹75 × 15 crore = ₹1125 crore

If you need the per-share value, it’s already given as ₹75.

Practical Application

Market-Based Valuation in Practice:

i. Publicly Traded Companies:

For companies listed on stock exchanges, market capitalization provides a quick and widely accepted valuation based on current market conditions.

ii. Mergers and Acquisitions:

In M&A scenarios, Precedent Transactions Analysis helps in valuing companies based on recent acquisition prices, reflecting what acquirers have been willing to pay for similar businesses.

iii. Industry Benchmarking:

Comparable Company Analysis is useful for assessing a company’s value relative to its peers, helping investors understand if the company is overvalued or undervalued compared to its industry.