Share Valuation

Share Valuation

While valuing the shares an accountant is to depend on the following assumptions:

(i) Sufficient number of buyers and sellers of the share are available in the market;

(ii) The seller does not sell his shares due to his urgent need; and

(iii) The purchaser of the shares does not like to pay a higher price in comparison with the reasonable price or market price of the shares.

Valuation of shares should be meaningful provided the above assumptions are satisfied. Practically, valuation of unquoted shares is very difficult although the same task can be done on the basis of past decisions of different leading cases and related surroundings. It should be remembered in this respect that the price of shares of a company which is quoted in the Stock Exchange may not be at par in comparison with the real financial position of the company.

Because, there are certain external factors (i.e., the demand and supply of shares, rate of bank interest, tax-policy of the government, political conditions etc.) which influence the value of shares. Under the circumstances, the valuation of such shares may be made necessary even if the same are quoted in the Stock Exchange (i.e. in the case of Amalgamation or Absorption).

Factors Affecting the Value of Shares:

The value of a share is greatly affected by the economic, political and social factors such as:

 (i) The nature of the company’s business

(ii) The economic conditions of the country

(iii) Other political and economic factors (e.g., possibility of nationalisation, excise duty on goods produced etc.)

(iv) The demand and supply of shares

(v) Proportion of liabilities and capital

(vi) Rate of proposed dividend and past profit of the company (vii) Yield of other related shares of the Stock Exchange etc.

Need for Share Valuation:

The necessity for valuation of a share arises in the following circumstances:

(i) For Estate Duty and Wealth Tax purposes

 (ii) For Amalgamation and Absorption schemes

(iii) For Gift Tax purposes

(iv) For discharge of debts and liabilities, in exceptional nature

(v) Purchasing shares for control

(vi) For selling shares of a shareholder to a purchaser (which are not quoted in the Stock Exchange)

(vii) For the conversion of one class of share to another class

(viii) For the compensation made to a company when the said company is being nationalised

(ix) For granting loans on the basis of security of shares (i.e. when the shares are held as security, etc.).

Equity Share Valuation:

The valuation of common stock or equity shares is relatively difficult as compared to the bonds or preferred stock. The cash flows of the latter are certain because the rate of interest on bonds and the rate of dividend on preference shares are known. The cash flows expected by investors on common stock are uncertain. The earnings and dividends on equity shares are expected to grow.

However, we can determine the value of equity shares:

(i) By developing certain models based on capitalisation of dividend, and

(ii) Capitalisation of earnings. Dividend capitalisation models are the basic valuation models.

Preference share is a hybrid security having features of both equity and debt. A fixed rate of dividend is paid on preference shares. Dividend on preference share is payable out of profits after paying interest on debt but before paying dividend on equity shares.

A preference share is also preferred in repayment as compared to equity share. Thus, preferred share is more risky than the bond but less risky than the equity share. The required rate of return on preferred stock is, therefore, greater than that of bonds.

Preferred stock or share can be with a maturity period or redeemable after a certain period or with perpetuity having no maturity period. The valuation of a preference share is very much similar to the valuation of a bond. The following formulas can be applied to find the value of the an preference share.

Value of a Redeemable Preference Share:

V_d = d/(1 +kp)¹ + d/(1 + kp)² + … … … d/(1 +kp)ⁿ P_n/(1 +kp)ⁿ

where, V_p = Value of preference share

d = Annual dividend per preference share

P_n = Maturity or redemption price of preference share

K_p = Required rate of discount on preference share.

Illustration 8:

Mr. A is considering the purchase of a 7% preference share of Rs. 1,000 redeemable after 5 years at par. What should he willing to pay now to purchase the share assuming that the required rate of return is 8%?

Solution:

Value of a Perpetual Preference Share:

If the preference share has no maturity date or is irredeemable and the future dividends are expected to be constant, the value can be calculated as below:

V_p = d/k_p

where, V_p = Value of preference share

d = Constant annual dividend

k_p = Required rate of discount or return on preference share.

Illustration 9:

Mr. A has a irredeemable preference share of Rs. 1,000. He receives an annual dividend of Rs. 80 annually. What will be its value if the required rate of return is 10%?

Solution:

V_p = d/k_p

= 80/0.10

= Rs. 800