MBA 205

EQUITY VALUATION

-Dr A.N.Garg

VALUATION OF SHARES

MBA 205

Valuation Of Shares: In most of the cases, shares are quoted on stock exchange; and for ordinary transactions in shares, the price prevailing on the stock exchange may be taken as the proper value. The stock exchange price does not hold good for very large lots. And not all shares are quoted on the stock exchange. Shares of private companies in any case will not be quoted. If therefore, shares of such a company have to change hands, the value of such shares will have to be ascertained. In addition, in the following 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 trust company. 4. For security purposes, e.g. where loans are raised on the security of shares.

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VALUATION OF SHARES
5. 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 company agree to transfer shares to another company and the transferee company 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. 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 may be equity or preference. It is worth mentioning here that before the 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 shareholders and at the time of winding up these shares are repaid in priority to the equity shares. These shares will be discussed in detail in the chapter on Sources of Funds. Here we will concentrate on its valuation part only. Like bonds, it is easy it is not very difficult to estimate cash flows associated with preference shares. These cash flows may include annual preference dividend and redemption value on maturity, in case the shares happen to be redeemable.

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VALUATION OF SHARES
The value of preference share would be the sum of the present values of dividends and the redemption value. Suppose an investor is considering the purchase of a 12 year, 10%, Rs.100 par value preference share, the redemption value being Rs. 120 on maturity. The investor s required rate of return is 10.5%. What should he be willing to pay for this share now? The investor would expect to receive Rs. 10 as preference dividend each year for 12 years and Rs.110 on maturity. We can use the present value annuity factor to value the constant stream of preference dividends and the present value factor to value the redemption 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. 101.30 It may be noted that the present value of Rs. 101.30 is a composite of the present value of dividends, Rs. 65.06 and the present value of the redemption value, Rs. 36.24. The Rs. 100 preference share is worth 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 preference share is Rs. 81.82, What returns do investors require? 9 81.82= ------Kp 9 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 shares because the preference shares have a fixed rate of dividend and hardly there is any difference between the face value and its market value. In case of equity shares the rate of dividend is not fixed and the declaration and payment of dividend is also discretionary. Because of the variability in the rate of dividend and uncertainty of cash flows, it is somewhat more difficult to value this type of shares 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 flows expected from an equity share consists of dividends that the owner 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 a capital 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 a stream of future dividends and a liquidating price when he also indulges in selling the shares. The expected cash flows consist only of future dividends and, therefore, the value of an ordinary share is generally determined by capitalising the future dividend stream at the opportunity cost of capital. Opportunity cost of capital is the return that the shareholder could earn from an investment of equivalent risk in the market. The value of a share is the present value of its future stream of dividends.

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VALUATION OF SHARES
Methods of Valuation: 1.Net Assets Basis/Intrinsic Value Method/Break-Up Value Method. 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 backing per 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 two approaches: (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. Nontrading 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 is contemplated. 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 and building, plant and machinery and goodwill etc. Provision should also be made for the costs of winding up and thus a reasonable indication may be forthcoming for the payment to be made to the members.

MBA 205

VALUATION OF SHARES
Intrinsic value of shares is useful for formulating amalgamation schemes. 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 a growing 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 this method the shares may be valued in any of the following three ways: (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 here means 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 providing for taxation, transfer to reserves, transfer to sinking fund for redemption of debentures and preference dividend etc. This method of valuation is suitable for small block of shares as small shareholders are invariably interested in dividends.

VALUATION OF SHARES

MBA 205

(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 are more 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 is based on EPS * P/E ratio. The P/E ratio is really the converse of the normal rate of return. If normal rate of return is say 20%, it means the P/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 Shares Market 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 shares which are quoted in a recognised stock exchange.

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VALUATION OF SHARES
Sometimes P/E ratio may mislead about the performance of a share. As already indicated, a high P/E ratio is considered good but it is worth mentioning here that the ratio may be high not because the share price is high but may be because of quite low earnings per share. Further, the interpretation of P/E ratio may become meaningless because of the measurement problems of EPS. A number of arbitrary assumptions and choices is then made to estimate the earnings. Accounting policies may be manipulated and altered which may distort the fair estimation of earnings. Non cash items such as depreciation may be included in the earnings. Thus, it may be difficult to interpret EPS meaningfully and rely on 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 factor means the earnings power of the company in relation to the net worth of the company. Average Weighted Taxed Profit Productivity Factor =------------------------------------------------ X 100 Average Weighted Net Worth Average weighted tax profit and average weighted net worth are ascertained by taking a number of years whose results are relevant for the future.

MBA 205

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 maintainable profits. These profits after necessary adjustments, if any, such as dividend on preference shares, effect of under- utilisation of productive capacity, making appropriation for rehabilitation and replacement purposes, are divided by the normal rate of return to arrive at the value of the companys business in relation to its equity shareholders. The value of companys business so obtained is divided by the number of equity shares to get the value of each equity share. The safest value that can be put on the equity shares is that on the basis of earnings ratio---- the other two values having some unnatural elements. 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 the maximum possible dividend may also not hold good since very few companies 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 an expected 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.

MBA 205

VALUATION OF SHARES
The present value of the share today, P0, will be determined as the present value of the expected dividend per share at the end of the first year, DIV1, plus the present value of the expected price of the share after a year, P1. DIV1+P1 P0 =-----------------1+Ke 2+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. In a well functioning capital market, there ought not to be any difference between the present value and the market value of a share. Investors would have full information and it would be reflected in the market price of the share in a well functioning market.

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VALUATION OF SHARES-In practice, there could be a difference between the present value and the market value of a share. An under valued share has a market price less than the present value of the share. On the other hand, an over valued share has a market price higher than the present value of the share. The share value after an year represents an expected growth or capital gain. 21-20 g= ------------ = 0.05 or 5% 20 P1-P0 g=------------P0

MBA 205

VALUATION OF SHARES
An investor can represent his expectation with regard to the future share price in terms of expected growth. In nutshell, the present value of a share is determined by its expected dividend divided by the difference of the shareholders capitalization, or required rate of return (Ke) and growth rate (g). If the investor would have expected the share price to grow at 5%, the value of the share today will be: DIV1 P0 = -----------------Ke - g 2 2 P0 = --------------- = -------------- =Rs.20. 0.15- 0.05 0.10

MBA 205

VALUATION OF SHARES
Multi Period Valuation: Now we have to understand the rationale for the new investor to purchase the share at the end of one year. He also expects a stream of dividends during the period he holds the share plus liquidating price of the share. The price next year (P1) will depend on expected dividend in year 2 and expected price of the share at the end of year 2. If we 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 dividends in 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

MBA 205

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 annual rate of 5% Assume that the expected dividend after a year (DIV1) is Rs. 2 and it is also expected to grow at the rate of 5% p.a. if the opportunity cost of capital is 15% what would be the price of the share if it were held for 5 years? 2.00 2.10 2.21 2.32 2.43 25.53 P0 = {------+-------+------+-------+ --------- } + -----------(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 share price at the end of five years is Rs. 12.69, the total present value of the 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 the companies grow with the passage of time and therefore generally there is an increase in the rate of dividends too. Many companies, in spite of having increased earnings, believe in maintaining the rate of dividend. Almost all the companies try to transfer a part their profit to reserves for the purpose of their future needs, may be to face rainy days, expansion, modernisation and diversification etc. This leads to the enhancement of owners equity as well as firms future earnings. If the number of shares does not change, this policy should tend to increase EPS, and, consequently, it should produce an expanding 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 internal rate of return, which is its return on equity (say, ROE), then it can be shown that the dividends will grow at a constant rate equal to the product 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 be resented by the shareholders who have acquired the shares for a short period of time. In the best interests of the company and long term shareholders a share valuation model should explicitly involve growth expectations.

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VALUATION OF SHARES
Super- Normal Growth: The dividends of a company may not grow at the same constant rate indefinitely. It may face a twostage 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 for the companys products may normalise and therefore, earnings and dividends may grow at a normal growth rate.