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Unit I: Shares and their valuation

Features of equity, Methods of valuation, Valuation of goodwill, valuation of shares- asset backing method, EPS method, Market value, Yield based methods, Fair value of shares, Dividend discount modelswith constant dividend, with constant growth, multistage growth models. P/E based valuation. Introduction Equity shares are floated in the market at face value, or at a premium or at a discount. Only companies with a track record or companies floated by other firms/companies with a track record are allowed to charge a premium. The premium is normally arrived at after detailed discussions with the merchant bankers. This is the first exercise involving the valuation of share by the company itself. After allotment of shares to the shareholders, the company may distribute its surplus profits as returns to investors. The returns to equity shareholders are in the form of distribution of business profits. This is termed as declaration of dividends. Dividends are declared only out of the profits of the company. Dividends are paid in the form of cash and are called cash dividends. When shares are issued additionally to the existing investors in the form of returns, they are called bonus shares. These decisions are taken in the annual general meeting of the shareholders. The announcement of dividend is followed by the book closure dates, when the register of shareholders maintained by the company is closed till the distribution of dividends. The shareholders whose names appear on the register on the date are entitled to receive the dividend payment. Cash dividend payments reduce the cash balance of the company while bonus share payments reduce the reserve position of the company. Thus, the dividends are a direct benefit from the company to its owners. It is an income stream to the owners of equity capital. Many expectations surround the companys quarterly announcement periods in terms of the dividend declared by the corporate enterprises to its shareholders. The payment of dividend itself is expected to influence the share price of the company. To the extent that cash goes out of the company, the book value of the company stands reduced and it is theoretically expected to lower the market price of the share. This is based on the argument that future expectations are exchanged for current benefits from the company in the form of dividends. While bonus shares do not reduce the cash flow of the company, they increase the future obligations of the company to pay extra dividend in the future. Bonus shares result in an increase in the number of existing shares. Hence, the company has to pay dividend on its newly issued bonus shares in addition to its existing number of shares. These bonus shares are different from stock splits. Stock splits simply imply a reduction in the face value of the instrument with an increase in the quantity of stock. A stock split does not increase the value of current equity capital. Bonus shares, on the other hand, increase the value of equity capital to the company. All these exercises by the company call for a renewed valuation of the shares traded in the secondary market. Hence, investment evaluation begins with the computation of the value of securities. Meaning and Nature: Goodwill is the value of the reputation of the firm which the business builds up due to its efficient service to its customers and quality of its products. It is a value of all favorable attributes relating to a business enterprise. It is not merely the past reputation but its continued existence in future that makes goodwill a valuable asset. It cannot be seen or touched. It is an intangible asset but not a fictitious asset.

The Institute of Chartered Accountants of India defines goodwill as an intangible asset arising from business connections or trade name or reputation of an enterprise. In this context, some of the definitions forwarded by various authors and experts in accounting are given below. According to Braden and Allyn Goodwill is an intangible asset compounded from a variety of successful business ingredients competent and energetic management, customer acceptance, a favorable location, a quality and profitable product, efficient production methods, an outstanding reputation, plus the expectation that these ingredients will continue to produce an above normal rate of return for an indefinite period of time. Dr. Canning defines goodwill as the present value of a firms anticipated excess earnings. According to Lord Eldon, Goodwill is nothing more than the probability that the old customers will resort to the old place. Factors affecting the value of goodwill: Goodwill relates to the profit earning capacity of the firm. Thus, the goodwill of a firm is affected by the following factors. The factors are: 1. Quality: If the firm enjoys good reputation for the quality of its products, there will be a ready sale and the value of goodwill, therefore, will be high. 2. Location: If the business is located in a prominent place, its value will be more. 3. Efficient management: If the management is capable, the firm will earn more profits and that will raise the firms value. 4. Competition: When there is no competition or competition is negligible , the value of those businesses will be high. 5. Advantage of patents: Possession of Possession of trade marks, patents or copyrights will increase the firms value. 6. Time: A business establishes reputation in course of time which is running for long period on profitable line. 7. Customers attitude: The type of customers which a firm has is important. If the firm has more customers, the value will be high. 8. Nature of business: A business having a stable demand is able to earn more profit and therefore has more goodwill. There are various methods of valuation of goodwill. These are: 1. Based on Simple Profit (Purchase of number of years, Capitalization of Simple profit), 2. Based on Super profit (Number of years purchase, sliding scale valuation method, capitalization method and annuity method), 3. Valuation of shares Net Assets Method,

a) Yield Method, b) Earning Capacity Method (Overall rate of Return Method), c) Fair Value Method

Valuation of shares:

a share represents an interest in a company. There are a number of ways in which

the shares of a company may be valued. It can be valued either as an entitlement to a share of future profits, or as an interest in the net assets that comprise the company. Therefore the choice of method of valuation is often governed by the reasons for the investment. The majority of shareholders of a company are interested in dividends. On the other hand a majority of shareholders may be interested in the realizable value of the company. S net assets since they can liquidate a company. There may be instances where a companys shares are not quoted on any stock exchange.

Factors affecting valuation of shares:

1. 2. 3. 4. 5. 6. 7. 8. The nature of the companys business. Percentage of dividend declared on the shares. The demand and supply of shares. The income yielding capacity of the company. The availability of sufficient assets over liabilities. General economic condition. Financial, political and others factors affecting the business. The fact that there is no free market for unquoted shares.

Methods of Valuation:Assets Backing Method:This method is also known as assets valuation method or intrinsic value method. Under this method the share value is simply the net assets or equity divided by the number of shares. The value of a share is first determined by ascertaining the value of net assets of a company and then dividing them by the number of shares. Therefore it is necessary to estimate the worth of the assets and liabilities. In ascertaining the amount of net assets the value of goodwill as well as the value of any contingent assets should also be taken into consideration. The following points are important and should be borne in mind for estimating the net assets: 1. The fixed assets of the company should be revalued at their net realizable value. 2. Inventory should also be taken at current market prices. 3. Investments should be taken at current market prices. These can be taken at cost if the fall in the market value is believed to be temporary. 4. Other current assets like bills payable or sundry debtors should be could be valued at their expected net realizable value. 5. All fictitious assets appearing in the Balance sheet are to be eliminated. 6. Goodwill may be valued on the basis of super profits. 7. All unrecorded assets and liabilities are to be taken into consideration.

From the aggregate value of the assets all external liabilities are to be deducted to arrive at the net assets figure. The external liabilities include sundry creditors, bills payable, Loans, Debentures etc. The net assets of a company as ascertained above, will be the basis of valuation shares and would be apportioned in the following manner:1. If the preference shareholders have priority to dividend as well as to capital on a winding up, they will be valued at par if they expect the same rate of dividend as specified in the shares. But if the required rate of return is more than the specified rate, they are to be valued above par to cover both capital and dividend. 2. After deducting the value of preference shares, as calculated above from the net assets the balance will be divided by the number of equity shares. The Assets Backing Methods is generally applied under the following circumstances: 1. For formulating scheme of amalgamation 2. For acquiring majority of the shares and controlling the company 3. When there is liquidation. Yield Value Method:This method is also known as Market value method. The world yield means a rate of return relating cash invested to cash receive. Yield may be Earning yield or Dividend yield. They are as under: Earning Yield: A company cannot grow and can be in a position to increase its dividends, if it distributes all of its profits as dividend. There are also legal restrictions by the companies act for distribution of profits as dividends. Therefore a shareholder will have interest both in the retained profits as well as distributed profits. Value per Share=

Expected Rate of Earnings (ERE) =

Dividend Yield: - there may circumstances where the shareholder has little or no influence over dividend policy. In such cases it may be more appropriate to value the shares based on dividends than earnings. The following matters must be taken into consideration while making an estimate of the expected future profits available for equity share dividends:1. The average past profits of the company require an adjustment, if necessary, should any special factor cause the future profits to differ from the past. 2. Adequate provision should be made for depreciation taxation and other liabilities. 3. The amount of profits to be set aside for preference share dividend.

Value per Share=

Dividend discount model According to the dividend discount model, conceptually a very sound approach, the value of an equity share is equal to the present value of dividends expected from its ownership plus the present value of the sale price expected when the equity share is sold. For applying the dividend discount model, we will make the following assumptions: (i) (ii) dividends are paid annually- this seems to be a common practice for business firms in India; and The first dividend is received one year after the equity share is bought.

Single-period valuation model Let us begin with the case where the investor expects to hold the equity share for one year. The price of the equity share will be: Where, P0 = current price of the equity share; D1 = dividend expected a year hence; P1 = price of the share expected a year hence; and r = Rate of return required on the equity share.

Ex.1 Prestiges equity share is expected to provide a dividend of Rs. 2.00 and fetch a price of Rs. 18.00 a year hence. What price would it sell for now if the investors required rate of return is 12 per cent?
Ans: - Rs. 17.86

What happens if the price of the equity share is expected to grow at a rate of g per cent annually? If the current price, P0, becomes P0 (1 + g) a year hence, we get:

Example2. The expected dividend per share on the equity share of Roadking Limited is Rs. 2.00. The dividend per share of Roadking Limited has grown over the past five years at the rate of 5 per cent per year. This growth rate will continue in future. Further, the market price of the equity share of Roadking Limited, too, is expected to grow at the same rate. What is a fair estimate of the intrinsic value of the equity share of Roadking Limited if the required rate is 15 per cent? Ans:- Rs. 20.00

Expected rate of return:In the preceding discussion we calculated the intrinsic value of an equity share, given information about (i) the forecast values of dividend and share price, and (ii) The required rate of return. Now we look at a different question: What rate of return can the investor expect, given the current market price and forecast values of dividend and share price? The expected rate of return is equal to:

R = D1/P0 + g
Example.3 .The expected dividend per share of Vaibhav Limited is Rs. 5.00. The dividend is expected to grow at the rate of 6 per cent per year. If the price per share now is Rs. 50.00, what is the expected rate of return?Ans:- Rs.16

Multi-period valuation Model:Having learnt the basics of equity share valuation in a single-period framework, we now discuss the more realistic, and also the more complex, case of multiperiod valuation. Since equity shares have no maturity period, they may be expected to bring a dividend stream of infinite duration. Hence the value of an equity share may be put as:

Now, what is the value of Pn in Eq.? Applying the dividend capitalization principle, the value of Pn, would be the present value of the dividend stream beyond the nth period, evaluated as at the end of the nth year. This means:

This is the same as Eq. which may be regarded as a generalized multi-period valuation formula. Eq. is general enough to permit any dividend pattern-constant, rising, declining, or randomly fluctuating. For practical applications it is helpful to make simplifying assumptions about the pattern of dividend growth. The more commonly used assumptions are as follows: a. The dividend per share remains constant forever, implying that the growth rate is nil (the zero growth model). b. The dividend per share grows at a constant rate per year forever (the constant growth model). c. The dividend per share grows at a constant extraordinary rate for a finite period, followed by a constant normal rate of growth forever thereafter (the two-stage model). d. The dividend per share, currently growing at an above-normal rate, experiences a gradually declining rate of growth for a while. a. Thereafter, it grows at a constant normal rate (the H model).

Zero Growth model:If we assume that the dividend per share remains constant year after year at a value of D, Eq. (b) becomes:

Remember that this is a straightforward application of the present value of perpetuity formula discussed in the previous chapter.

Constant growth model:One of the most popular dividend discount models assumes that the dividend per share grows at a constant rate (g). The value of a share, under this assumption, is:

Example. Ramesh Engineering Limited is expected to grow at the rate of 6 per cent per annum. The dividend expected on Rameshs equity share a year hence is Rs. 2.00. What price will you put on it if your required rate of return for this share is 14 per cent? Ans: Rs.25

Price Earnings Based valuation:Earnings (net income or net profit) are the money left after a company meets all its expenditure. To allow for comparisons across companies and time, the measure of earnings is stated as earnings per share (EPS). This figure is arrived at by dividing the earnings by the total number of shares outstanding. Thus, if a company has one crore shares outstanding and has earned Rs. 2 crore in the past 12 months, it has an EPS of Rs. 2.00. Rs. 20,000,000/10,000,000 shares = Rs. 2.00 earnings per share EPS alone would not be able to measure if a companys share in the market is undervalued or overalued. Another measure used to arrive at investment valuation is the Price/Earnings (P/E) ratio that relates the market price of a share with its earnings per share. The P/E ratio divides the share price by the EPS of the last four quarters. For example, if a company is currently trading at Rs. 150 per share with a EPS of Rs. 5 per share, it would have a P/E of 30. The P/E ratio or multiplier has been used most often to make an investment decision. A high P/E multiplier implies that the market has overvalued the security and a low P/E multiplier gives the impression that the market has undervalued the security. When the P/E multiple is low, it implies that the earnings per share is comparatively higher than the prevailing market price. Hence, the conclusion that the company has been undervalued by the market. Assume a P/E multiplier of 1.0. The implication is that the earnings per share is equal to the prevalent market price. While market price is an expectation of the future worth of the firm, the earnings per share is the current results of the firm. Hence, the notion that the firm has been undervalued by the market. On the other hand, a high P/E ratio would imply that the market is overvaluing the security for a given level of earnings. Asian paints had a P/E ratio of 25.3 on July 26, 2005. The market price as on that date was Rs. 457.65 and the earnings per share was Rs. 18.1. Zee Telefilms, had a consistent P/E multiplier.

ICICI Bank, had a price of Rs. 509.25 and PE ratio of 18.8 on the same date. The interpretation of overvaluation will hold good when the market is expected to adjust towards the real worth of the company. A consistent high ratio, on the other hand, implies that the future returns expectations from the company is consistently good and that the high P/E ratio need not necessarily indicate a overvalued position for the company. The forward P/E valuation is another technique that is based on the assumption that prices adjust to future P/E multipliers. The assumption is that shares typically trade at a constant P/E and therefore the future value of a share can be calculated by comparing the current P/E with the future P/E (as predicated using analysts estimated earnings for that year). The forecasted market price is calculated as [Price* (P/E, current)/ (P/E, future)]. For example, if current market price is Rs. 20, current P/E is 4 and forecasted P/E is 2.5, the forecast price is Rs. 32.