Valuation of Shares

Valuation of shares is the process of determining the fair value (intrinsic value) of the company shares weather it may be the listed in exchange or not. In this article, we will talk about the valuation, types of valuation and its approach and where it will be useful and why it requires.

What is Share Valuation

Valuation is the process of determining a company’s share value. Share valuation is done based on quantitative techniques, and share value will vary depending on market demand and supply. The publicly traded companies' share price 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.

Nationalization: To compensate shareholders when a company is nationalized.

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 show the true picture or large blocks of shares are under transfer 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 a large amount 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 for valuing the shares during amalgamation, absorption, or liquidation of companies.

Income Approach

This approach has two different methods, namely the Discounted Cash Flow (DCF) or Price Earnings Capacity (PEC) method. The DCF method uses the projection of future cash flows to determine the fair value, and if this data is reasonably available, it can be used. The PEC method uses historical earnings, and if an entity has not been in the business for a long time and has just started its operations, then this method 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 can be obtained in the open market. If a set of peer companies are 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 one valuation method will fit any purpose hence, various share valuation methods depend on the purpose, data availability, 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 have to be considered at their realisable value.
• Valuation of goodwill as a part of intangible assets is important
• Even unrecorded assets and liabilities are to be considered
• The fictitious assets, such as preliminary expenses, discount on issue of shares and debentures, accumulated losses, etc., should be eliminated.

To determine the net value of assets, deduct all the external liabilities from the company's total asset value. 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 comparable publicly traded companies' share prices and comparable private companies' asset or stock sales. Data related to private companies can be obtained from various proprietary databases available in the market. What is more important is choosing comparable companies. Many pre-conditions need to be considered while selecting, such as the nature and volume of the business, industry, size, 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:

ii. Dividend Yield

Under this method, shares are valued on the basis of 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 like IFRS, GAAP, or regulations by SEBI.
• Stakeholder Perspectives: Investors may prioritise 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 a critical process for determining the fair value of a company’s shares, essential for informed decision-making in transactions, investments, and regulatory compliance. By employing asset-based, income-based, or market-based approaches such as the Asset Approach for capital-intensive firms, Discounted Cash Flow (DCF) or Price Earning Capacity (PEC) for income-focused valuations, and market comparisons for listed companies, one can select the most suitable method based on the company’s nature, purpose of valuation, and data availability.

Combining multiple methods often enhances reliability, while addressing limitations like undervaluing intangibles or relying on assumptions ensures a more accurate and robust valuation. Aligning with regulatory standards and considering stakeholder perspectives further strengthens the valuation process, enabling fair and strategic financial decisions.