You are interested to buy a Tiny (Small scale industry)
industry which is coming for sale. The owner of the said company Bargains for
more than 3 times of the present profit, a successful industry. According to
you, the Machineries with all accessories connected with the entire Building
and Land alone is enough to be given money. If you are starting that same said
business, what may be the expenses, up to that level you can afford money,
Naturally. Then why he is expecting more? What is the reason? You are confused
and Questioning within yourself !
Similarly you are ready to buy a Residential House in an
Apartment in a Busy Area. In that area the market price/sq.ft is around
Rs.2000/-. Your friend who has also booked a House in that Apartment for the
same price. Even in Newspapers the market price of that area is predicted as
the same price. After confirming, you are deciding to buy that house. Your
decision is based on the market price. It is called as a type of valuation.
Whenever people talk about equity investments, one must have
come across the word "Valuation". In financial parlance, Valuation
means how much a company is worth of. Talking about equity investments, one
should have an understanding of valuation.
Valuation means the intrinsic worth of the company. There
are various methods through which one can measure the intrinsic worth of a
company. This section is aimed at providing a basic understanding of these
methods of valuation. They are mentioned below:
You have said as a Type. It means is there any other types
in valuing. Yes, there are,
1) In future, the
gains able to be obtained from that house can be calculated and
predictable as present cost.
2) If you are
constructing a House for your own then the actual expenses.
3) Supposing if
you are purchasing only for investment, if the real Estate sector goes down,
then the actual value in
that period.
In the same manner, stocks valuation can also be valued in
several ways! They are given below,
1) P/E Yield
Method,
2) Book Value
Method,
3) Market value
Method,
4) Replacement
cost Method,
5) Discounted cash
flow Method,
6) Worst Case/
Best Case Method.
The above methods can be seen in detail as follows ;-
1) P/E Yield
Method,
The stock market price divided by the stocks income is
called P/E. The stocks you ought to buy, P/E can be compared with the same
sector based another stock. While comparing either Low or High P/E will be
known. But you must be aware in carefully selecting the Organization. It is also
termed as “PEER GROUP”. The stocks we are ready to purchase, and company both
must be in same sector, of same type of Business. Both Companies (Turn over)
sales more or less must be same.
If you are selecting Indian Bank as your choice. It is an Public
Sector Bank. An another public sector bank can alone be compared for our
Analysis. Comparing with another Bank and Finance Instutions is not advisable.
Even in public sector 2 Equivalent banks can alone be compared. Indian Bank
cannot be compared with State Bank of India. But it can be compared with
Indian Overseas Bank. Because both are having their Branches in South India, commonly. Gross income is almost
nearby,
Indian Banks as on 31.03.2011, Total income – 10,543 Crores,
Indian Overseas Banks as on 31.03.2011, Total income –
13,327 Crores,
Similarly common Scalar quantities can be Utilized and PEER
GROUP can be formed.
INDIAN BANK can be compared with CORPORATION BANK,
INDIAN BANK can be compared with SYNDICATE BANK,
INDIAN BANK can be compared with ORIENTAL BANK,
INDIAN BANK can be compared with UNION CO-OPERATIVE BANK,
INDIAN BANK can be compared with ALLAHABAD BANK,
Even though Allahabad Bank is having most of its Branches in
North India it can also be taken for our comparison.
Now we have formed a same factored “PEER GROUP”. Let us see
our Peer Groups P/E Average ( Having Latest income statement ) Indian Banks P/E
Peer Group Average Vs ----- closely held other banks can be compared. Why it
differs can be Analyzed ! With other scalar quantities ( P/BV, Dividend Yield,
Debts yet to be received percentage, Income growth, No: of Branches,
Shareholding pattern, and others ) can be compared. Then we can come to a
conclusion why it differs ? With those results buying Indian Bank stocks or not
can be decided.
The above seen valuation can only be advisable for stocks
listed in Stock Market. Because we can get all the Data’s required for us. Let
us assume that if you are trying to buy a company not listed in the stock market.
Then the stock market listed same sector based companies P/E average can be
taken, to be purchased. Companies net gain when multiplied with the average
P/E, the result shows the companies resultant value. From the above value, how
less if possible to buy is much better.
In financial markets, stock valuation is
the method of calculating theoretical values of companies and their stocks.
The main use of these methods is to predict future market prices, or more
generally potential market prices, and thus to profit from price movement –
stocks that are judged undervalued (with respect to their
theoretical value) are bought, while stocks that are
judged overvalued are sold, in the expectation that undervalued
stocks will, on the whole, rise in value, while overvalued stocks will, on the
whole, fall.
In the view of fundamental analysis,
stock valuation based on fundamentals aims to give an estimate of their intrinsic value of
the stock, based on predictions of the future cash flows and profitability of
the business. Fundamental analysis may be replaced or augmented by market criteria
– what the market will pay for the stock, without any necessary notion of
intrinsic value. These can be combined as "predictions of future cash
flows/profits (fundamental)", together with "what will the market pay
for these profits?". These can be seen as "supply and demand"
sides – what underlies the supply (of stock), and what drives the (market)
demand for stock?
In the view of others, such as John Maynard Keynes,
stock valuation is not a prediction but aconvention, which serves to facilitate
investment and ensure that stocks are liquid, despite being underpinned by an illiquid
business and its illiquid investments, such as factories.
Fundamental criteria (fair value)
The most theoretically sound stock valuation method,
called income valuation or the discounted cash flow (DCF)
method, involves discounting of the profits (dividends, earnings, or
cash flows) the stock will bring to the stockholder in the foreseeable future,
and a final value on disposal. The discounted rate normally includes
a risk premium which is commonly based on
the capital asset
pricing model.
In July 2010, a Delaware
court ruled on appropriate inputs to use in discounted cash flow analysis in a
dispute between shareholders and a company over the proper fair value of the
stock. In this case the shareholders' model provided value of $139 per share
and the company's model provided $89 per share. Contested inputs included the
terminal growth rate, the equity risk premium, and beta.
STOCK VALUATION METHODS
Stocks have two types of valuations. One is a value created
using some type of cash flow, sales or fundamental earnings analysis. The other
value is dictated by how much an investor is willing to pay for a particular
share of stock and by how much other investors are willing to sell a stock for
(in other words, by supply and demand). Both of these values change over time
as investors change the way they analyze stocks and as they become more or less
confident in the future of stocks.
The fundamental valuation is the valuation that people use
to justify stock prices. The most common example of this type of valuation methodology
is P/E ratio, which stands for Price to Earnings Ratio. This form of valuation
is based on historic ratios and statistics and aims to assign value to a stock
based on measurable attributes. This form of valuation is typically what drives
long-term stock prices.
The other way stocks are valued is based on supply and
demand. The more people that want to buy the stock, the higher its price will
be. And conversely, the more people that want to sell the stock, the lower the
price will be. This form of valuation is very hard to understand or predict,
and it often drives the short-term stock market trends.
There are many different ways to value stocks. The key is to
take each approach into account while formulating an overall opinion of the
stock. If the valuation of a company is lower or higher than other similar
stocks, then the next step would be to determine the reasons.
EARNINGS PER SHARE (EPS).
EPS is the total net income of the company divided by the
number of shares outstanding. They usually have a GAAP EPS number (which means
that it is computed using all of mutually agreed upon accounting rules) and a
Pro Forma EPS figure (which means that they have adjusted the income to exclude
any one time items as well as some non-cash items like amortization of goodwill
or stock option expenses). The most important thing to look for in the EPS
figure is the overall quality of earnings. Make sure the company is not trying
to manipulate their EPS numbers to make it look like they are more profitable.
Also, look at the growth in EPS over the past several quarters / years to
understand how volatile their EPS is, and to see if they are an underachiever
or an overachiever. In other words, have they consistently beaten expectations
or are they constantly restating and lowering their forecasts?
The EPS number that most analysts use is the pro forma EPS.
To compute this number, use the net income that excludes any one-time gains or
losses and excludes any non-cash expenses like stock options or amortization of
goodwill. Then divide this number by the number of fully diluted shares
outstanding. You can easily find historical EPS figures and to see forecasts
for the next 1–2 years by visiting free financial sites such as Yahoo Finance
(enter the ticker and then click on "estimates").
By doing your fundamental investment research you'll be able
to arrive at your own EPS forecasts, which you can then apply to the other
valuation techniques below.
Price to Earnings (P/E).
Now that you have several EPS
figures (historical and forecasts), you'll be able to look at the most common
valuation technique used by analysts, the price to earnings ratio, or P/E. To
compute this figure, take the stock price and divide it by the annual EPS
figure. For example, if the stock is trading at $10 and the EPS is $0.50, the
P/E is 20 times. To get a good feeling of what P/E multiple a stock trades at,
be sure to look at the historical and forward ratios.
Historical P/Es are computed by taking the current price
divided by the sum of the EPS for the last four quarters, or for the previous
year. You should also look at the historical trends of the P/E by viewing a
chart of its historical P/E over the last several years (you can find on most
finance sites like Yahoo Finance). Specifically you want to find out what range
the P/E has traded in so that you can determine if the current P/E is high or
low versus its historical average.
Forward P/Es reflect the future growth of the company into
the figure. Forward P/Es are computed by taking the current stock price divided
by the sum of the EPS estimates for the next four quarters, or for the EPS
estimate for next calendar of fiscal year or two.
P/Es change constantly. If there is a large price change in
a stock you are watching, or if the earnings (EPS) estimates change, the ratio
is recomputed.
Growth Rate.
Valuations rely very heavily on the expected
growth rate of a company. One must look at the historical growth rate of both
sales and income to get a feeling for the type of future growth expected. However,
companies are constantly changing, as well as the economy, so solely using
historical growth rates to predict the future is not an acceptable form of
valuation. Instead, they are used as guidelines for what future growth could
look like if similar circumstances are encountered by the company. Calculating
the future growth rate requires personal investment research. This may take
form in listening to the company's quarterly conference call or reading press
release or other company article that discusses the company's growth guidance.
However, although companies are in the best position to forecast their own
growth, they are far from accurate, and unforeseen events could cause rapid
changes in the economy and in the company's industry.
And for any valuation technique, it's important to look at a
range of forecast values. For example, if the company being valued has been
growing earnings between 5 and 10% each year for the last 5 years, but believes
that it will grow 15 - 20% this year, a more conservative growth rate of 10 -
15% would be appropriate in valuations. Another example would be for a company
that has been going through restructuring. They may have been growing earnings
at 10 - 15% over the past several quarters / years because of cost cutting, but
their sales growth could be only 0 - 5%. This would signal that their earnings
growth will probably slow when the cost cutting has fully taken effect.
Therefore, forecasting an earnings growth closer to the 0 - 5% rate would be
more appropriate rather than the 15 - 20%. Nonetheless, the growth rate method
of valuations relies heavily on gut feel to make a forecast. This is why
analysts often make inaccurate forecasts, and also why familiarity with a
company is essential before making a forecast.
PRICE EARNINGS TO GROWTH (PEG) RATIO.
This valuation technique has really become popular over the
past decade or so. It is better than just looking at a P/E because it takes
three factors into account; the price, earnings, and earnings growth rates. To
compute the PEG ratio, divide the Forward P/E by the expected earnings growth
rate (you can also use historical P/E and historical growth rate to see where
it's traded in the past). This will yield a ratio that is usually expressed as
a percentage. The theory goes that as the percentage rises over 100% the stock
becomes more and more overvalued, and as the PEG ratio falls below 100% the
stock becomes more and more undervalued. The theory is based on a belief that
P/E ratios should approximate the long-term growth rate of a company's
earnings. Whether or not this is true will never be proven and the theory is
therefore just a rule of thumb to use in the overall valuation process.
Here's an example of how to use the PEG ratio. Say you are
comparing two stocks that you are thinking about buying. Stock A is trading at
a forward P/E of 15 and expected to grow at 20%. Stock B is trading at a
forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A is 75%
(15/20) and for Stock B is 120% (30/25). According to the PEG ratio, Stock A is
a better purchase because it has a lower PEG ratio, or in other words, you can
purchase its future earnings growth for a lower relative price than that of
Stock B. Nerbrand Z.
Given that investments are subject to revisions
of future expectations the Nerbrand Z utilises uncertainty of consensus
estimates to assess how much earnings forecasts can be revised in standard
deviation terms before P/E rations return to normalised levels. This
calculation is best done with I/B/E/S consensus estimates. The market tend to
focus on the 12 month forward P/E level but this ratio is dependent on earnings
estimates which are never homogenous. Hence there is a standard deviation of 12
month forward earnings estimates.
where H[P/E] = normalised P/E, e.g. a 5 year historical
average of 12 month forward P/E ratios.
E12 = mean 12 month forward earnings estimates
stdev(E12) = standard deviation of 12 month forward earnings
estimates.
A negative number indicates that earnings can be downgraded
before valuations normalise. As such, a negative number indicate a valuation
adjusted earnings buffer. For example, if the 12 month forward mean EPS
forecast is $10, the price of the equity is $100, the historical average P/E
ratio is 15, the standard deviation of EPS forecast is 2 then the Nerbrand Z is
-1.67. That is, 12 month forward consensus earnings estimates could be
downgraded by 1.67 standard deviation before P/E ratio would go back to 15.
RETURN ON INVESTED CAPITAL (ROIC).
This valuation technique measures how much money the company
makes each year per dollar of invested capital. Invested Capital is the amount
of money invested in the company by both stockholders and debtors. The ratio is
expressed as a percent and you should look for a percent that approximates the
level of growth that you expect. In its simplest definition, this ratio
measures the investment return that management is able to get for its capital.
The higher the number, the better the return.
To compute the ratio, take the pro forma net income (same
one used in the EPS figure mentioned above) and divide it by the invested
capital. Invested capital can be estimated by adding together the stockholders
equity, the total long and short term debt and accounts payable, and then
subtracting accounts receivable and cash (all of these numbers can be found on
the company's latest quarterly balance sheet). This ratio is much more useful
when you compare it to other companies that you are valuing.
RETURN ON ASSETS (ROA).
Similar to ROIC, ROA, expressed as a percent, measures the
company's ability to make money from its assets. To measure the ROA, take the
pro forma net income divided by the total assets. However, because of very
common irregularities in balance sheets (due to things like Goodwill,
write-offs, discontinuations, etc.) this ratio is not always a good indicator
of the company's potential. If the ratio is higher or lower than you expected,
be sure to look closely at the assets to see what could be over or understating
the figure.
PRICE TO SALES (P/S).
This figure is useful because it compares the current stock
price to the annual sales. In other words, it tells you how much the stock
costs per dollar of sales earned. To compute it, take the current stock price
divided by the annual sales per share. The annual sales per share should be
calculated by taking the net sales for the last four quarters divided by the
fully diluted shares outstanding (both of these figures can be found by looking
at the press releases or quarterly reports). The price to sales ratio is
useful, but it does not take into account any debt the company has.
For
example, if a company is heavily financed by debt instead of equity, then the
sales per share will seem high (the P/S will be lower). All things equal, a
lower P/S ratio is better. However, this ratio is best looked at when comparing
more than one company.
Market Cap. Market Cap, which is short for Market
Capitalization, is the value of all of the company's stock. To measure it,
multiply the current stock price by the fully diluted shares outstanding.
Remember, the market cap is only the value of the stock. To get a more complete
picture, you'll want to look at the Enterprise Value.
Enterprise Value is equal to the total value of the company, as it is trading
for on the stock market. To compute it, add the market cap (see above) and the
total net debt of the company. The total net debt is equal to total long and
short term debt plus accounts payable, minus accounts receivable, minus cash.
The Enterprise Value is the best approximation of what a company is worth at
any point in time because it takes into account the actual stock price instead
of balance sheet prices[citation needed].
When analysts say that a company is a "billion dollar" company, they
are often referring to its total enterprise value. Enterprise Value fluctuates
rapidly based on stock price changes.
EV to Sales.
This ratio measures the total company value as compared to
its annual sales. A high ratio means that the company's value is much more than
its sales. To compute it, divide the EV by the net sales for the last four
quarters. This ratio is especially useful when valuing companies that do not
have earnings, or that are going through unusually rough times. For example, if
a company is facing restructuring and it is currently losing money, then the
P/E ratio would be irrelevant. However, by applying a EV to Sales ratio, you
could compute what that company could trade for when its restructuring is over
and its earnings are back to normal.
EBITDA.
EBITDA stands for earnings before interest, taxes,
depreciation and amortization. It is one of the best measures of a company's
cash flow and is used for valuing both public and private companies. To compute
EBITDA, use a company's income statement, take the net income and then add back
interest, taxes, depreciation, amortization and any other non-cash or one-time
charges. This leaves you with a number that approximates how much cash the
company is producing. EBITDA is a very popular figure because it can easily be
compared across companies, even if all of the companies are not profitable.
EV to EBITDA.
This is perhaps one of the best measurements of whether or not
a company is cheap or expensive.[citation needed] To
compute, divide the EV by EBITDA (see above for calculations). The higher the
number, the more expensive the company is. However, remember that more
expensive companies are often valued higher because they are growing faster or
because they are a higher quality company. With that said, the best way to use
EV/EBITDA is to compare it to that of other similar companies.
Approximate valuation approaches
Average growth approximation: Assuming that two stocks have
the same earnings growth,
the one with a lower P/E is a better value. The P/E method
is perhaps the most commonly used valuation method in the stock brokerage
industry. By using comparison firms, a target
price/earnings (or P/E) ratio is selected for the company, and then the future
earnings of the company are estimated. The valuation's fair price is simply
estimated earnings times target P/E. This model is essentially the same model
as Gordon's model, if k-g is estimated as the dividend payout ratio (D/E)
divided by the target P/E ratio.
Constant growth approximation:
The Gordon model or Gordon's growth model is the best known of a class of discounted dividend
models. It assumes that dividends will increase at a constant growth
rate (less than the discount rate) forever. The valuation is given by the
formula:
.
and the following table defines each symbol:
Symbol
|
Meaning
|
Units
|
P
|
estimated stock price
|
$ or € or £
|
N
|
|
$ or € or £
|
k
|
discount rate
|
%
|
g
|
|
%
|
Limited high-growth period approximation: When a stock has a
significantly higher growth rate than its peers, it is sometimes assumed that
the earnings growth rate
will be sustained for a short time (say, 5 years), and then the growth rate
will revert to the mean.
This is probably the most rigorous approximation that is practical.
While these DCF models are commonly used, the uncertainty in
these values is hardly ever discussed. Note that the models diverge for k = g and hence are extremely
sensitive to the difference of dividend growth to discount factor. One might
argue that an analyst can justify any value (and that would usually be one
close to the current price supporting his call) by fine-tuning the
growth/discount assumptions.
Implied Growth Models
One can use the Gordon model or the limited high-growth
period approximation model to impute an implied growth estimate. To do this,
one takes the average P/E and average growth for a comparison index, uses the
current (or forward) P/E of the stock in question, and calculates what growth
rate would be needed for the two valuation equations to be equal. This gives
you an estimate of the "break-even" growth rate for the stock's
current P/E ratio. (Note : we are using earnings not dividends here because
dividend policies vary and may be influenced by many factors including tax
treatment).
Imputed growth acceleration ratio
Subsequently, one can divide this imputed growth estimate by
recent historical growth rates. If the resulting ratio is greater than one, it
implies that the stock would need to experience accelerated growth relative to
its prior recent historical growth to justify its current P/E (higher values
suggest potential overvaluation). If the resulting ratio is less than one, it
implies that either the market expects growth to slow for this stock or that
the stock could sustain its current P/E with lower than historical growth
(lower values suggest potential undervaluation).
Comparison of the IGAR across
stocks in the same industry may give estimates of relative value. IGAR averages
across an industry may give estimates of relative expected changes in industry
growth (e.g. the market's imputed expectation that an industry is about to
"take-off" or stagnate). Naturally, any differences in IGAR between
stocks in the same industry may be due to differences in fundamentals, and
would require further specific analysis.
Market criteria (potential price)
Some feel that if the stock is listed in a well organized
stock market, with a large volume of transactions, the listed price will be
close to the estimated fair value.[citation needed] This
is called the efficient market
hypothesis.
On the other hand, studies made in the field of behavioral finance tend
to show that deviations from the fair price are rather common, and sometimes
quite large.[citation needed]
Thus, in addition to fundamental economic criteria, market
criteria also have to be taken into account market-based valuation.
Valuing a stock is not only to estimate its fair value, but also to determine
its potential price range, taking into account market behavior aspects.
One of the behavioral valuation tools is the stock image, a coefficient that bridges the
theoretical fair value and the market price.
COMPANY VALUATION
NET ASSET VALUE (NAV)
NAV or Book value is one of the most commonly used methods
of valuation. As the name suggests, it is the net value of all the assets of
the company. If you divide it by the number of outstanding shares, you get the
NAV per share.
One way to calculate NAV is to divide the net worth of the
company by the total number of outstanding shares. Say, a company’s share
capital is Rs. 100 crores (10 crores shares of Rs. 10 each) and its reserves
and surplus is another Rs. 100 crores. Net worth of the company would be Rs.
200 crores (equity and reserves) and NAV would be Rs. 20 per share (Rs. 200
crores divided by 10 crores outstanding shares).
NAV can also be calculated by adding all the assets and subtracting
all the outside liabilities from them. This will again boil down to net worth
only. One can use any of the two methods to find out NAV.
One can compare the NAV with the going market price while
taking investment decisions.
DISCOUNTED CASH FLOWS METHOD (DCF)
DCF is the most widely used technique to value a company. It
takes into consideration the cash flows arising to the company and also the
time value of money. That’s why, it is so popular. What actually happens
in this is, the cash flows are calculated for a particular period of time (the
time period is fixed taking into consideration various factors). These cash
flows are discounted to the present at the cost of capital of the company.
These discounted cash flows are then divided by the total number of outstanding
shares to get the intrinsic worth per share.
The valuation of
shares may be done by an accountant for two reasons :
(i) where there is no market price as in the case of a
proprietary company.
(ii) where for special reasons, the market price does not
reflect the true or intrinsic value of the shares.
The problem does not arise if the shares are quoted on the
stock exchange as it provides a ready means of ascertaining the value placed on
such shares by the buyers and sellers.
NEED FOR VALUATION
The following are the circumstances where need for valuation
of shares arises :
(i) Where companies amalgamate or are similarly
reconstructed, it may be necessary to arrive at the value of the shares held by
the members of the company being absorbed or taken over. This may also be
necessary to protect the rights of dissenting shareholders under the provisions
of the Companies Act, 1956.
(ii) Where shares are held by the partners jointly in a
company and dissolution of the firm takes place, it becomes necessary to value
the shares for proper distribution of the partnership property among the
partners.
(iii) Where a portion of the shares is to be given by a
member of proprietary company to another member as the member cannot sell it in
the open market, it becomes necessary to certify the fair price of these shares
by an auditor or accountant.
(iv) When a loan is advanced on the security of shares, it
becomes necessary to know the value of shares on the basis of which loan has
been advanced.
(v) When preference shares or debentures are converted into
equity shares, it becomes necessary to value the equity shares for ascertaining
the number of equity shares required to be issued for debentures or preference
shares which are to be converted.
(vi) When equity shareholders are to be compensated on the
acquisition of their shares by the Government under a scheme of
nationalization, then it becomes necessary to value the equity shares for
reasonable compensation to be given to their holders.
FACTORS AFFECTING VALUATION OF SHARES
Valuation of shares depends upon the purpose of valuation,
the nature of the business of the company concerned, demand and supply for
shares, the government policy, past performance of the company, growth
prospects of the company, the management of the company, the economic climate,
accumulated reserves of the company, prospects of bonus or rights issue,
dividend declared by the directors and many other related factors.
The basic factor (or principle) in the valuation of shares
is the dividend yield that the investor expects to get as compared to the
normal rate prevailing in the market in the same industry. For small investors,
rate of dividend declared by the directors plays an important role in the
valuation of shares whereas investors holding bulk of shares (say 15% to 30%)
would be able to affect the dividend rate, therefore for them total profits (or
earning capacity) play an important part in the valuation of shares. Thus, for
a bulk holders of shares net assets including goodwill or capitalized value on
the basis of the expected profits may be basis of valuation of shares.
METHODS OF VALUATION
The different methods of valuing shares may be broadly
classified as follows :
1. Net Assets Basis (or Intrinsic Value or Break up Value)
Method.
2. Earning Capacity (or Yield Basis or Market Value) Method.
3. Dual (or Fair Value) Method.
(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. If this view is accepted,
there are two approaches ;
(i) To value the shares on the net tangible assets basis
(excluding the goodwill).
(ii) To value the shares on the net tangible assets plus an
amount for goodwill.
(i) Net Tangible Assets Basis (Excluding the Goodwill)
Under this method, it is necessary to estimate net tangible
assets of the company (Net Tangible Assets = Assets - Liabilities) in order to
value the shares, In valuing the figures by this method, care must be exercised
to ensure that the figures representing the assets arc sound, i.e., intangible
assets and preliminary expenses are eliminated and all liabilities (whether in
books or not) are deducted from the value of the tangible assets. Non-trading
assets are also included in the assets and the assets are taken at their market
value, i.e., replacement value.
Where both types of shares are issued by a company, the
shares would be valued as under:
(1) If preference shares have priority as to capital and
dividend, then the preference shares are to be valued at par.
(2) After the preference shareholders are paid the net
tangible assets are to be divided by the number of equity shares to calculate the
value of each share. If at the time of valuation there is an uncalled capital,
then the uncalled equity share capital be added with the net tangible assets in
order to value the shares fully paid up. The valuation of shares for the
shareholders who have calls on arrears will be valued as a percentage on their
paid up value with the nominal value of shares. If the company has equity
shares of varying face value, the total replacement value of assets left after
deducting the paid up. value of preference shares is first apportioned to
different categories of equity shares on the basis of paid up value of such
categories. The amount thus arrived at would be divided by the number of shares
in each of such categories to get the value of each share of such categories.
(3) If the preference shares are participating and rank
equally with the equity shares, then the value per share would be in proportion
to the paid up value of preference shares and equity shares.
Share ownership in a
private company is usually quite difficult to value due to the absence of a
public market for the shares. Unlike public companies that have the price per
share widely available, shareholders of private companies have to use a variety
of methods to determine the approximate value of their shares. Some common
methods of valuation include comparing valuation ratios, discounted
cash flow analysis (DCF), net tangible assets, internal
rate of return (IRR), and many others.
The most common method and easiest to implement is to compare valuation ratios
for the private company versus ratios of a comparable public company. If you
are able to find a company or group of companies of relatively the same size
and similar business operations, then you can take the valuation multiples such
as the price/earnings ratio and apply it to the
private company.
For example, say your private company makes widgets and a similar-sized public
company also makes widgets. Being a public company, you have access to that
company's financial statements and valuation ratios. If the public company has
a P/E ratio of 15, this means investors are willing to pay $15 for every $1 of
the company's earnings per share.
In this simplistic example, you may find it
reasonable to apply that ratio to your own company. If your company had
earnings of $2/share, you would multiply it by 15 and would get a share price
of $30/share. If you own 10,000 shares, your equity stake would be worth
approximately $300,000.
You can do this for many types of ratios: book value, revenue, operating income, etc. Some methods use several
types of ratios to calculate per-share values and an average of all the values
would be taken to approximate equity value.
DCF analysis is also a popular method for equity valuation. This method
utilizes the financial properties of the time-value of money by forecasting
future free cash flow and discounting each cash flow by a certain discount rate
to calculate its present value. This is more complex than a comparative
analysis and its implementation requires many more assumptions and
"educated guesses." Specifically, you have to forecast the future
operating cash flows, the future capital expenditures, future growth rates and
an appropriate discount rate. (Learn more about DCF in our Introduction
to DCF Analysis.)
Valuation of private shares is often a common occurrence to settle shareholder
disputes, when shareholders are seeking to exit the business, for inheritance
and many other reasons. There are numerous businesses that specialize in equity
valuations for private business and are frequently used for a professional
opinion regarding the equity value in order to resolve the issues listed.
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