VALUATIO N OF SHARES

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What are Shares??? The capital of the company is divided into small number of units called as shares. ´Shareµ implies a unit having property rights. Shares of a company are generally quoted in the stock exchange. So the shares are quoted and the market quotations are often taken as the representing value of share on a particular date. But the price of share may not always be warranted by the fina ncial position of the company because stock exchange prices are influenced by

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Bank rate Taxation Political influence etc

Types of shares 

Preference shares: Carries 2 rights as per section 85 of Companies Act. They have a right to receive dividend at a fixed rate before any dividend is paid on equity shares.
On winding up of the Company, they have a right on return on capital before anything is paid to equity shareholders. 

Equity shares: Is a share which is not a preference share. They control the aff airs of business hence have right to profits after all preference dividend is paid off.

The necessity of valuation arises out of following reasons: 1. When a block of share is to be purchased so as to acquire controlling interest on amalgamation or merger of companies. 2. When the company is nationalized and the shareholders of the company are compensated by the government. 3. When the shares are to be taken as a security against loan. 4. When a class of shares is converted to another class of share or debenture . 5. When the partners of a company jointly hold some shares of a company for ascertaining the amount to be distributed among the partners on dissolution.

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6. Under the scheme of nationalization when the shares of the company are taken over by the government. 7. Tax purposes ( i.e. wealth tax)

Methods of valuation of shares depend on the purpose and factors affecting the valuation of shares. 1. 2. Intrinsic Value Method Yield method

3. Earning capacity method 4. Capitalization and earning capacity 5. Fair value 6. Valuation of Preference shares 1. INTRINSIC VALUE METHOD This method involves estimation of current value of assets and liabilities and determination of the exact net worth or net assets of the business so as to give the value of shares as under: Value of shares = Net worth Or Net worth Share capital x face value (paid up) value of each share

Number of shares

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Net worth: All the credit balances appearing in the balance sheet should be carefully studied so for accumulated profits & reserves may not be considered. All fictitious assets should be excluded. Special care should be taken to include assets and liabilities that are not disclosed in the balance sheet. Goodwill: It comprises of a real asset in a sense that it may be sold for value n hence it is rational to include the value of goodwill. When there is both equity and preference shares the valuation will be made with reference to the provision contained in The Articles of Association of the company. If both shares enjoy the same benefit: Net worth/Number of total shares = value per share

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In other cases the amount payable to the preference share holder:

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Intrinsic value of that of class of shares each share

= Total assets backing for equity shares X actual paid up Total amount of paid up equity capital value of

ASSETS BACKING METHOD  :LWKRXWVHSDUDWLRQRIJRRGZLO O Sundry assets [Including goodwill and non trading assets like investments but Excluding fictitious assets like misc expenses or P/L (DR.) ] Less: liabilities: External liabilities CONTINGENT LIABILITIES Net worth Less: preference shareholders claim 00 00 -000 000 -00 000 Add: notional calls partly paid shares Net assets backing equity shares or available to equity shareholders + 00 000 Rs. 000

Value of each fully paid shares = net assets available for equity shareholders No of equity shares Intrinsic value of each partly paid share= Intrinsic value of each fully paid equity share notional call per share

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:LWKVHSDUDWHYDOXDWLRQJRRGZLOO   5V Step a calculation of capital employed Sundry assets 00 Excluding:
i. ii. iii. Goodwill but including goodwill at cost pa id for Non trading assets Fictitious assets -00 -00 Capital employed 00

Less: iv. Current liabilities & provisions v. contingent liabilities

Step b Step c

calculate goodwill trading capital employed Add: value of goodwill computed Add: non trading asset (At market price, if given, otherwise at cost)

Less: preference shareholders claim Add: notional call on partly paid shares Less: goodwill at cost Less: proposed dividend (for valuation of shares ex- dividend) Net assets (including goodwill) available for equity shareholders

00 00 00 00 - 00 00 00 00 - 00 - 00 00

Intrinsic value of each fully paid equity share = net assets available for equity shareholders Number of equity shares

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2 .YIELD METHOD

Under this method profit determines the value of shares . 1. On the basis of expected return on capital emplo yed. 2. On the basis of expected future dividends . A. Return On Capital Basis:

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Rate of return on capital x paid up value per share Normal rate of return

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(Rate of return: profit earned /capital employed) x 100

Where, Profit earned means: less debenture interest and preference dividend but after charging income tax. Capital employed includes share capital, long term loans, and reserves

B. Dividend basis: following steps: Expected profit available for equity dividend is calculated by deducting from estimated future maintainable profits, income tax, preference dividends and transfer to reserves. (Expected rate of return: Expected profit available for equity dividend/paid up) x paid up value per share

The method to be used in valuation depends on the number of shares involved

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When large block of shares involved: return on capital employed When small number of shares involved: dividend basis.

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3. EARNING CAPACITY METHOD

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This method takes into account the earning potentials of a company rather than return of the shareholders. The earning capacity method takes into account total earning of the company before any appropriation. This method involves the following steps.

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Calculation of future maintainable profits.  Calculation of capital employed. (calculation shown earlier in  Ascertaining the rate of earnings.  Determining the normal rate of return.  Determination of value of shares. Calculation of future maintainable profits
Rs. Net profit before tax Less: non trading income Less: additional depreciation on fixed assets (if necessary) Less: additional expenses Less: provision for tax Less: transfer to reserve Less preference dividend (for current year) Maintainable profits 00 00 00 00 00 00 00 00

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The capital employed should mean Equity capital employed as i.e. Equity capital plus retained earnings. The preference share capital, The Long term borrowing and debentures were to be excluded. 

Rate of earning
= Profits after interest, tax & preference dividend X 100 Equity capital 

Value of Equity shares

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Earning Rate

X Paid up value

Normal rate of return

4. CAPITALIZATION OF EARNING CAPACITY METHOD Under this method profits available for equity shareholders as calculated under capitalization of method, are capitalized on the basis of normal rate of return.

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Then the value of equity shares is ascertained by dividing the capitalized profits by the number of equity shares as shown under = Future Maintainable Profits X100 Normal Rate of Return 

Capitalized Value of profits 

Value of Equity share

= Capitalized value of Profits No. of equity shares

5. FAIR VALUE METHOD Some authorities are of the view that neither the intrinsic value nor the yield value is correct but the proper method of valuation is to take average of both the methods.

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Formula: 

(Intrinsic value + yield value)/2
Or 

Intrinsic value + Capitalized/Earning capacity
2

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6. VALUATION OF PREFERENCE SHARES

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A preference shareholder is particularly interested in the security of capital and consistency of returns. That is why he is anxious for a priority of repayment of his capital/dividend or both.

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Usually preference shares are not separately valued. Rate of return on these shares remain fixed. So when liquidation is anticipated, preference shares will be valued and on the basis of dividend.  Formula: (Rate of preference dividend /Normal yield on preference share) x paid up value of each preference share.

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Normal yield on preference shares will usually be lower than that of equity shares because a greater safety is available to the preference share holders. The following points must be kept in the mind while calculating the value of preference shares. In the case preference shares are cumulative and participating then besides arrears they will also be entitled to shares in the surplus of the company, left af ter returning equity capital. However, if the preference shares do not have any preference (priority) with regard to repayment of capital and dividend, the values of preference shares shall be calculated as if these are equity shares If preference shares are non-cumulative and non-participating the value of each preference shares shall be equal to its paid up value If preference shares are cumulative and non-participating the value will be determined after arrears of preference dividend are added back to their paid up capital.

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