What is Valuation of Shares? Importance, Methods, Purpose and Need

What is Valuation of Shares?

The share capital is the most important requirement of a business. It is divided into a ‘number of indivisible units of a fixed amount. These units are known as ‘shares’.

According to Section 2 (46) of the Companies Act, 1956, a share is a share in the share capital of a company and includes stock except where a distinction stock and shares are expressed or implied. The person who is the owner of the shares is called ‘Shareholder’ and the return he gets on his investment is called ‘Dividend’.

The meaning of value may be subjective and objective. Value of a pen for an examinee in the examination hall is subjective, called ‘value-in-use. Its value for a buyer is the monetary value, i.e., its price is objective value, called ‘value-in-exchange’.

Value of a share means the money value attached to the share. It may be the book value (value written in the books of account), or the price at which it can be sold or purchased. The value of a share is first stated in the Articles of Association of the Company.

It is also stated in the Balance sheet of all companies. The value, stated in the Balance Sheet (or in the books of account and Articles of Association) is called ‘book-value of a share. The value of a share (the price) at which it can be sold or purchased is a market value that may be more or less than the book value.

The problems relating to the valuation of shares may be discussed under the following broad heads:

  1. Valuation of Equity Shares.
  2. Valuation of Preference Shares.

Importance of Valuation of Shares

The importance of valuation of shares can be understood from the following:

  1. Stock Exchange quoted value often fails to reflect the real worth of share. This is applicable only to ordinary transactions of shares, when a small number of shares are purchased or sold. Quoted price is not suitable for purchase or sale of major or controlling shares.

    Further, all shares are not quoted on Stock Exchange. Hence, valuation of unquoted shares is also necessary for transferring shares from one person to another person.

  2. The importance of valuation of shares also arises in case of amalgamation of companies when there is the need for having a fair valuation of shares to settle the purchase price.

  3. Sometimes preference shares and debentures are converted into equity shares as per the terms of issue. In such case, a fresh valuation method should be adopted for equity shares to calculate the exchange ratio.

  4. To obtain loans from financial institutions shares and debentures can be offered as security. For such a purpose valuation of shares is essential to assess the real worth of the shares pledged for getting loans.

  5. When a Public Sector Undertaking is converted into a limited company by means of public issue of shares of such undertaking, valuation of these shares becomes essential.

    When the shares of a limited company are taken over by the government under a scheme of nationalisation, it is necessary to value the shares of the concerned company in order to compensate the shareholders.

Purpose and Need of Valuation of Shares

The need for valuation of shares may be felt by any company in the following circumstances:

  1. For assessment of Wealth Tax, Estate Duty, Gift Tax, etc.

  2. Amalgamations, absorptions, etc.

  3. For converting one class of shares to another class.

  4. Advancing loans on the security of shares.

  5. Compensating the shareholders on acquisition of shares by the Government under a scheme of nationalisation.

  6. Acquisition of interest of dissenting shareholder under the reconstruction scheme, etc.

Methods of Valuation of Shares

The issues relating to the valuation of shares may be discussed under the following broad heads:

  1. Net Asset Method
  2. Yield Method
  3. Fair Value Method
  4. Intrinsic Value Method

Net Asset Method

This is also known as the Balance Sheet Method or Intrinsic Method or Break-up Value Method or Valuation of Equity basis or Asset Backing Method. Here the emphasis is on the safety of investment as the investors always need safety for their investments.

Under this method, the net assets of the company are divided by the number of shares to arrive at the net asset value of each share. Under this method, the net assets of the company including goodwill and non-trading assets are divided by the number of shares issued to arrive at the value of each share.

If the market value of the assets is available, the same is to be considered and in the absence of such information, the book values of the assets shall be taken as the market value.

Calculation of Net assets of a company

Computation of Net AssetsRs.
Net Assets—–
Fixed Assets (Market Value)—–
Investments (Market Value)——
Current Assets (Market Value)——
Goodwill, if any (Market Value)——
Total
Less:
Currents Liabilities—-
Debentures—-
Pref. Share Capital (with arrear Dividend)—-
Net Assets/Funds available for equity shareholders—-
Total
Intrinsic Value of each share = Funds available for equity shareholders ÷ No. of equity shares
Calculation of Net assets of a company

Yield Method

Yield is the effective rate of return on investments that are invested by the investors. It is always expressed in terms of percentage. Since the valuation of shares is made on the basis of Yield, it is called Yield-Basis Method.

The yield here means the possible return that an investor gets out of his holdings like dividends, bonus shares, right shares. If the return is more, the price of the share is also more. Under this method, the valuation of shares is obtained by comparing the expected rate of return with a normal rate of return.

Calculation of Yield Value of Share:

1. Calculation of expected return:

Expected Returns = Expected Profits ÷ Equity x 100

2. Value of Share = Expected Rate ÷ Normal Rate x Paid-up Value of Share

Fair Value Method

There are some accountants who do not prefer to use Intrinsic Value or Yield Value for ascertaining the correct value of shares. They however prescribe the Fair Value Method which is the mean of Intrinsic value and Yield Value method and the same provides a better indication about the value of shares than the other methods.

Fair Value = (Intrinsic Value + Yield Value) ÷ 2

Intrinsic Value Method

This method is also called as Assets Backing Method, Real Value Method, Balance Sheet Method or Break-up Value Method. Under this method, the net assets of the company including goodwill and non-trading assets are divided by the number of shares issued to arrive at the value of each share.

If the market value of the assets is available, the same is to be considered and in the absence of such information, the book values of the assets shall be taken as the market value. While arriving at the net assets, the fictitious assets such as preliminary expenses, the debit balance in the Profit and Loss A/c should not be considered.

The liabilities payable to the third parties and to the preferred shareholders are to be deducted from the total asset to arrive at the net assets.

The funds relating to equity shareholders such as General Reserve, Profit, and Loss Account, Balance of Debenture Redemption Fund, Dividend Equalisation Reserve, Contingency Reserve, etc. should not be deducted.

Value of Equity Share = Net Assets available to Equity Shareholders ÷ No. of Equity Shares

Example:

Balance Sheet

ParticularsParticulars
1000, 8% Preference Shares of ` 100 each fully paid1,00,000Buildings70,000
4,000 Equity Shares of ` 100 fully paid4,00,000Furniture3,000
Reserves1,50,000Stock (Market value)4,50,000
Profit and Loss account5,10,000Investment at cost (face value 4,00,000)3,35,000
Creditors48,000Debtors2,80,000
Bank60,000
Preliminary Expenditure10,000
Total12,08,000 12,08,000
Balance Sheet

The building is now worth ` 3,50,000 and the Preferential shareholders are having a preference as to capital and dividend.

Valuation of Equity ShareIntrinsic Value Method
Building
Furniture
Stock
Investment
Debtors
Bank
3,50,000
3,000
4,50,000
3,35,000
2,80,000
60,000
Total Assets
Less: Creditors
14,78,000
(48,000)
Net Assets
Less: Preference Share Capital
14,30,000
(1,00,000)
Assets Available for Equity Shareholders13,30,000
Valuation of Equity Share

Value of Equity Share = Net Assets available to Equity Shareholders ÷ No. of Equity Shares

= 13,30,000 ÷ 4,000

= ₹ 332.5

Intrinsic value of each equity share = ₹ 332.50


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