Financial Management

Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation

UNIT 3: VALUATION OF SECURITIES:

Some important definitions:

• Sec 2(50) “Issued Capital” means such capital as the company issues from time to time for
subscription
• Sec 2(64) “paid – up share capital” or “share capital paid – up” means such aggregate amount of
money credited as paid – up as is equivalent to the amount received as paid –up in respect of
shares issued and also includes any amount credited as paid – up in respect of shares of the
company, but does not include any other amount received in respect of such shares, by whatever
name called.
• Sec 2(84) “Share” means a share in the share capital of a company and includes stock
• Sec 2(88) “Sweat Equity Shares” means such equity shares as are issued by a company to its
directors or employees at a discount or for consideration, other than cash, for providing their
know-how or making available rights in the nature of intellectual property rights or value
additions, by whatever name called;
• Equity Capital is a term which denotes the capital contributed by owners of the company.
Different values are attached to equity shares which are Par value, Book value, Market value and
Issue Price. In fact, all these prices does not represent the true value or intrinsic value of share.
Under the circumstances, the valuation of share may be made necessary even if the same are
quoted in the Stock Exchange. Particularly in the case of Amalgamation or Absorption Valuation
of Share becomes necessary.

Concept of Valuation:

Value means an amount regarded as a suitable equivalent for something else, a fair price or return for
items, goods and services. Value is a worth in usefulness or importance to the professor. Valuation is an
act or process of assessing value or price; it is an estimation of worth. In case of valuation of share usually
listed shares are transacted on the basis of stock exchange quotations. The shares of a Company, quoted
on stock exchange, have a value different from the face value.

The stock exchange prices of shares are not generally acceptable because the price quoted in the stock
exchange is based on demand, supply, business cycle etc. The actions and opinions of the investors and
their fears, guess etc. also reflect on the price of shares. Valuation of shares means determination of the
fair value of the shares shown in the balance sheet. Valuation of shares does not mean putting the value of
shares owned by the shareholder as on the date of the balance sheet. It is a critical examination of the
value of share capital. Valuation certifies correctness of the value of shares.

Need for Valuation:

i. Assessments under estate duty, wealth tax, gift tax etc.

Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
ii. Purchase of a block of shares generally involving acquisition of controlling interest in
the Company
iii. Formulations of schemes of amalgamation, absorption etc.
iv. Acquisition of interest of dissenting shareholders under s reconstruction scheme.
v. Conversion of preference shares into equity shares
vi. Advancing loans on the security of shares
vii. Compensating shareholders on the acquisition of their shares, by the government
under a scheme of nationalization.

Special factors affecting Valuation of Shares:

i. The nature of the Company’s business

ii. The economic conditions of the country
iii. Other political and economic factors
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
viii. Dividend declared by the Company in the past
ix. Net Tangible asset of the Company
x. Restrictions on investment
xi. Peace and security of the Company
xii. Goodwill of the Company
xiii. Capacity of directors
xiv. Type of management

Valuation of Shares – Methods:

➢ Net Asset Method

This is also termed as Balance Sheet Method or Asset Backing Method or Intrinsic Method. Here the
emphasis is on the safety of investment as the investors always need safety for their investments. In case
of this method, the net assets of the Company (including goodwill and non trading assets) are divided by
the number of issued shares to arrive at the asset backing for each share. For instance, if the assets total is
Rs 50,000, liabilities total is Rs 10,000 and the number of shares is 20,000, the value of each share will be
Rs 2 as per this method. The following points should be kept in mind while valuing shares according to
this method:

i. A proper value should be placed on the goodwill of the business.

ii. Fictitious assets such as preliminary expenses, debit balance in profit and loss account etc should be
excluded.
iii. All other assets should be taken at their market value. In absence of information, book value may be
taken.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
iv. Liabilities payable to third parties and preference share capital should be deducted from the total
assets. It should be noted that items forming a part of the shareholder’s funds should not be deducted.
v. The net assets so arrived at should be divided by the number of equity shares to arrive at the value of
the shares.

This method of valuation is generally not recommended for going concerns since in their case yield is the
predominant factor. However, in case of companies like investment companies, such a basis of valuation
may be acceptable since yield, in their case primarily depends on the asset position. Similarly, in case of
companies having highly uneven past results, this method of valuation may be the only choice since no
reliable information is available about the expected earning of the Company. This method is also useful to
determine the value of shares during amalgamation, absorption and liquidation.

➢ Yield Method:

The yield basis of valuation may take any of the following two forms:

a) Valuation based on Rate of Return

b) Valuation based on Productivity

A. Valuation based on Rate of Return:

The term “rate of return” refers to the return which a shareholder earns on his investment. It may further
be classified as rate of dividend and rate of earning.

a. Valuation based on rate of dividend:

This method of valuation is particularly suitable for valuing small blocks of shares. The value of a share
according to this method can be found out by applying the following formula:

Paid up value of share * Possible rate of dividend/Normal rate of dividend

For example, if the paid up value of a share is Rs 80, normal rate of dividend is 10% and based on past
results expected/possible dividend is 12% then the value of the share is Rs 96.

b. Valuation based on rate of earning:

This method of valuation is particularly suitable for valuing a large block of the Company’s shares. A big
investor is more interested in what the Company earns and not simply in what the Company distributes.
This is because the rate of earning of the Company explains the effective utilization of the Company’s
assets. In case the Company does not distribute 100% of its earnings among it shareholders, it, as a matter
of fact strengthens the financial position of the Company.

The value of a share according to this method can be calculated by the following formula:

Paid – up value* Possible earning rate/Normal earning rate

Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
For example, if the paid up value of a share is Rs 80, possible earning rate is 20% and normal rate is 16%,
then value of share is Rs 100.

B. Valuation based on productivity factor:

Productivity factor represents the earning power of the Company in relation to the value of the assets
employed for such earning. The factor is applied to the net worth of the Company on the valuation date to
arrive at the projected earnings of the Company. The projected earnings are multiplied by the appropriate
capitalization factor to arrive at the value of the Company’s business. The total value is divided by the
number of shares to ascertain the value of each share.

➢ Fair Value of a share:

The fair value of a share is the average of the values obtained by the Net Asset Method and the Yield
Method. The results of the same provide a better indication about the value of shares.

➢ Value of Right Shares:

A Company, if it desires can increase its capital by further issue of shares. In that case, the existing
shareholders must be given the priority of purchasing those shares according to their paid up value. As the
existing shareholders have got such a right to purchase the newly issued shares, they are called Right
Shares.

In order to make proper valuation of right relating to Right Shares, the market value of the old holdings
and the total issue price of the new holdings must be added and the same must be divided by the total
number of new and old holdings. Value of the Right Shares will be the difference between the result that
is obtained and market value of shares.

Value of Right = Number of Right Shares/Total Holdings*(Market Value – Issue Price)

➢ Valuation of Bonus Shares:

The Company issues new shares to existing shareholders which is known as Bonus shares instead of
paying a dividend in cash. After the bonus issue, there will be an increase in the number of equity shares
with no corresponding increase in the available net assets to the equity shareholders. As a result, the
intrinsic value of each share will always be less after a bonus issue.

➢ Valuation of Preference Shares:

In India, preference shares have a priority as to payment of dividend and repayment of capital over equity
shares in the event of a Company’s winding up. Their valuation is generally on Dividend Basis according
to the following formula:

Paid up value* Average Maintainable Dividend Rate/Normal Rate of return

Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
For example, if the paid up value of a share is Rs 80, average dividend rate is 12% and normal rate of
return is 10%, the value of the preference share will be Rs 96.

In case the dividend on cumulative preference shares is in arrears, the present value of such arrears of
divided (if there is a possibility of payment) should be added to the value of a preference share calculated
as above.

The dividend basis for valuation of preference shares is useful only in those cases where the preference
share capital has adequate assets backing and the company is a going concern. In case the preference
share does not have adequate assets backing or the company is going into liquidation, it will be
appropriate to value the preference shares according to the net assets method.

Valuation of Debentures/Bonds:

A bond or debenture is an instrument of long term debt issued by a borrower. The technique of Valuation
of Bonds or Debentures is, generally, determined through the technique known as the Capitalization
technique. The process of determination of the present value of a Bond or Debenture can be considered
under two headings viz.

a. When a bond or debenture is redeemable

b. When a bond or debenture is irredeemable

i. Present Value of a Redeemable Bond or Debenture:

When a bond or debenture is redeemable, its present value can be determined by estimating its future
cash flows, and then, discounting the estimated future cash flows at an appropriate capitalization rate
or discount rate. The estimated cash flows from the bond or debentures consist of the stream of future
interest payments plus the principal repayment. The appropriate capitalization rate or discount rate to
be applied to discount the cash flow from the bond or debenture will depend upon the risk associated
with the bond or debenture. If the risk is low, a lower discount rate will be applied. On the other hand,
a higher discount rate would be applied if the risk is high.

V = I1/(1+K) + I2/(1+K)(1+K) + I3/(1+K)(1+K)(1+K) + I4+M/(1+K)(1+K)(1+K)(1+K)

V = the present value of the bond/debenture

I = annual interest payment

K = the capitalization rate or discount rate

M = the maturity value

Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
(The above formula is for a Maturity period of 4 years)

ii. Present Value of a Perpetual or Irredeemable Bond or Debentures:

When a bond or debenture is irredeemable, its present value can be determined by simply discounting
the stream of interest payments for the infinite period by an appropriate capitalization rate or discount
rate. The following formula maybe used to determine the present value of the bond or debenture.

V = I/Kd

V = Present value of the Bond/Debenture

I = Annual Interest payment

Kd = Capitalization rate or discount rate

Risk, Return and Share Value Relationship:

The share price Valuation models consider the risk involved, return expected and possible growth. The
decisions made by the Finance Manager are bound to affect either all or two or one of the above variables.
The relation between these variables and the decisions of the Finance Manager affect the value of the
shares.

It is widely recognized that investment in equity shares is a risky preposition as the return from the firm in
the form of dividends may vary from one year to another. Also some shares are more risky as compared
to others. The investors will not commit funds to equity shares unless the expected rate of return is
commensurate with the risk. If due to the decision of the Finance Manager, the risk involved increases,
then the value of the share will decrease and vice versa.

Return in the form of expected dividend stream also affects the value of the share. If a financial decision
affects the expectations of the investors with respect to returns, then the value of shares will also show a
variation.

In practice, a financial decision will simultaneously affect the risk as well as the return expected by the
shareholders. Normally when the return increases, the risk is also expected to increase and vice versa.
However, the net effect on the value of the share depends upon relative risk- return trade off.