Valuation of Shares

Valuation of shares is the process of determining the fair value (intrinsic value) of a company's shares, whether or not they are listed on an exchange. In this article, we will discuss valuation, its types, the approaches involved, where they are useful, and why they are required.

Key Highlights:

• Share valuation helps determine the fair value of shares for investment, transactions, taxation, and compliance purposes.
• Common valuation methods include asset-based, income-based (DCF/PEC), and market-based approaches.
• The valuation method depends on the company’s nature, financial data, and valuation objective.

What is Share Valuation?

Valuation is the process of determining a company’s share value. Share valuation is based on quantitative techniques, and share value varies with market demand and supply. The share prices of publicly traded companies can be found easily. 

Valuation is critical and often complex due to limited market data. Share valuation provides a foundation for informed decision-making in transactions, investments, or regulatory compliance.

When is the Valuation of Shares Required?

Listed below are some of the instances where the valuation of shares is important:

• Selling a Business: To determine the fair market value of your business before a sale.
• Securing Loans: When using shares as collateral for bank loans.
• Mergers and Acquisitions: For mergers, acquisitions, reconstructions, or amalgamations, where accurate valuation ensures fair negotiations.
• Converting Shares: When converting preference shares to equity shares.
• Employee Stock Ownership Plans (ESOPs): To establish the value of shares offered to employees.
• Tax Assessments: For compliance with wealth tax, gift tax, or capital gains tax regulations (e.g., under IRS rules in the U.S. or Income Tax Act in India).
• Litigation: When share valuation is required for legal disputes or settlements.
• Investment Companies: To assess the value of shares held in their portfolios.
• Nationalisation: To compensate shareholders when a company is nationalised.
• Publicly Traded Shares: To validate market quotations, especially when large blocks of shares are transferred, or market prices do not reflect true value due to volatility or manipulation.

Sometimes, even publicly traded shares have to be valued because the market quotation may not reflect the true picture or large blocks of shares are being transferred, etc.

How to Choose The Share Valuation Method

There are various reasons for adopting a particular method for share valuation. It generally depends on the purpose. Using a combination of methods typically provides a more reliable valuation. 

Let’s see under each approach what the main reason is:

Assets Approach

If a company is capital-intensive and has invested heavily in capital assets or has a large volume of capital work in progress, an asset-based approach can be used. This method is also applicable to valuing shares during the amalgamation, absorption, or liquidation of companies.

Income Approach

This approach has two methods: Discounted Cash Flow (DCF) and Price Earnings Capacity (PEC). The DCF method uses projections of future cash flows to determine fair value, and when this data is reasonably available, it can be used. 

The PEC method uses historical earnings; if an entity has not been in business long and has just started operations, it cannot be applied.

Market Approach

Under this approach, the market value of the shares is considered for valuation. However, this approach is feasible only for listed companies whose share prices are publicly available. 

If a set of peer companies is listed and engaged in a similar business, then such a company’s share public prices can also be used.

What are the Methods of Share Valuation?

No single valuation method serves all purposes; hence, various share valuation methods depend on the purpose, data availability, the nature and volume of the company, etc.

Asset-based

This approach is based on the value of the company’s assets and liabilities, including intangible assets and contingent liabilities. This approach may be very useful to manufacturers, distributors, etc., where a huge volume of capital assets is used. 

This approach is also used as a reasonableness check to confirm the conclusions derived under the income or market approaches. Here, the company’s net asset value is divided by the number of shares to arrive at the value of each share. 

The following are some of the important points to be considered while valuing shares under this method:

• The company's entire asset base, including current assets and liabilities such as receivables, payables, and provisions, should be considered.
• Fixed assets must be measured at their realisable value.
• Valuation of goodwill as a part of intangible assets is important
• Even unrecorded assets and liabilities are to be considered
• Fictitious assets, such as preliminary expenses, discounts on the issue of shares and debentures, accumulated losses, etc., should be eliminated.

To determine the net value of assets, deduct all external liabilities from the company's total assets. The net value of assets so determined has to be divided by the number of equity shares to determine the share's value. The formula used is as follows:

Value per share = (Net Assets – Preference Share Capital) / (No. of Equity Shares)

Example: A company has total assets worth 10 million (including 2 million in goodwill), external liabilities of 3 million, and preference share capital of 1 million. It has 500,000 equity shares.

Net Assets = 10M - 3M = 7M

Value per share = (7M - 1M) ÷ 500,000 = 12 per share.

Limitations:

• May undervalue intangible assets like brand value or intellectual property.
• Not ideal for service-based or early-stage companies with minimal assets.

Income-Based Approach

This approach focuses on the expected future earnings or cash flows of the business. It is suitable for valuing minority stakes or businesses with stable earnings. Standard methods include Discounted Cash Flow (DCF) and Price Earnings Capacity (PEC).

Key Steps:

• Determine the company’s profit available for distribution (after taxes and reserves).
• Calculate the capitalised value using a capitalisation rate (the expected rate of return, adjusted for risk).
• Divide the capitalised value by the number of shares.

Formula: Capitalised Value = Expected Annual Earnings ÷ Capitalisation Rate

Value per share = Capitalised Value ÷ Number of Equity Shares

DCF Method: Projects future cash flows and discounts them to present value using a discount rate (e.g., Weighted Average Cost of Capital).

Formula: DCF = Σ (Cash Flow t ÷ (1 + Discount Rate) ^t), where t is the time period.

PEC Method: Uses historical earnings multiplied by a price-to-earnings (P/E) ratio.

Formula: Value per share = (Average Annual Earnings × P/E Ratio) ÷ Number of Shares

Example (PEC): A company earns 1 million annually (after taxes), has a P/E ratio of 10, and has 200,000 shares.

Capitalized Value = 1M × 10 = 10M

Value per share = 10M ÷ 200,000 = 50 per share.

Limitations:

• DCF is sensitive to assumptions about growth rates and discount rates.
• PEC is less reliable for startups or companies with volatile earnings.

Market-based

The market-based approach generally uses share prices of comparable publicly traded companies and asset or stock sales of comparable private companies. Data on private companies can be obtained from various proprietary databases on the market. 

What is more important is choosing comparable companies. Many preconditions need to be considered when selecting, such as the nature and volume of the business, the industry, size, and financial condition of similar companies, the transaction date, etc. 

There are two different methods when using the yield method (Yield is the expected rate of return on investment), which are explained below.

Earning Yield

Shares are valued based on expected earnings and the normal rate of return. Under this method, the value per share is calculated using the following formula:

Expected Rate of Earning = (Profit After Tax / Equity shares paid up value) X 100

Value Per Share = (Expected Rate of Earning / Normal Rate of Return) X Paid Up Equity Value

Dividend Yield

Under this method, shares are valued based on the expected dividend and the normal rate of return. The value per share is calculated by applying the following formula:

Expected rate of dividend = (profit available for dividend/paid-up equity share capital) X 100

Limitations and Practical Considerations

• Asset-Based: May not capture future growth potential or intangible value.
• Income-Based: Relies heavily on assumptions, making it prone to errors if projections are inaccurate.
• Market-Based: Requires reliable peer data, which may not exist for niche or private firms.
• Regulatory Compliance: Valuation must align with standards such as IFRS and GAAP, as well as SEBI regulations.
• Stakeholder Perspectives: Investors may prioritize income-based methods, while regulators may require asset-based valuations for tax purposes.
• Sensitivity Analysis: For DCF, test multiple scenarios (e.g., varying growth rates) to assess valuation robustness.

Conclusion

Share valuation is the process of determining the fair value of a company’s shares for investment, transactions, and regulatory purposes. Different methods, such as asset-based, income-based (DCF/PEC), and market-based valuation, are used depending on the company’s nature and financial data. 

Combining multiple approaches often yields a more accurate valuation by considering factors such as future growth, intangible assets, market conditions, and compliance requirements.