MEANING
Valuation of shares is defined as the process of calculating the value of shares of any company. The value of each share depends on some external factors such as market demand and supply. This process is done through various quantitative techniques.
IMPORTANCE
The Valuation of Shares is very important for any company as it helps to manage the business. It tracks the performance in terms of estimated change in value and not just in revenue terms. It also helps to track the effectiveness of the Strategic Decision Making Process.
The Valuation of shares is also important when Business has to be sold out and the value of the business is required to be known. Some of the cases where the valuation is important are Acquisition, Amalgamation, Merger and Reconstruction. The Valuation of Shares is also important for the Investors as higher valuations would mean more money per share can be sold to the investors and it will be easier for them to borrow the money.
EFFECT OF VALUATION IN DECISION MAKING
Valuation of shares helps in the decision making by following ways:-
1. The growth of the business depends on Valuation of Shares. The higher the rate of growth, the higher shall be the value of business.
2. Business Risks and issues related to the owner and management are reduced by the Valuation process.
3. It increases the cash flow and the investors are interested in future cash flows.
METHODS
Following are the Five Methods of Valuation of Shares:-
1. Asset Backing Method:- It is also called Net Asset Method. The Valuation made in this method is based on the assets of the company. Under this Method, the valuation of each share is calculated as the value of the total net assets of the company (including goodwill) divided by the total number of shares issued with an entitlement to assets on wind up.
2. Yield- Basis Method:- Yield is defined as the effective rate of return(ROR) on investments which is invested by the investors. Under this method, The Valuation is made on the basis of Yield. It is expressed in terms of Percentage.
3. Price- Earning Ratio Method:- The Price- Earning Ratio (P/E Ratio) is calculated by dividing the Market Value Price Per Share by the Company’s Earning Per Share (EPS). The Investors get a better sense of the value of share of the company by this ratio. It shows the willingness of the market to pay for a stock today based on the past or future earnings. If this ratio is high, then the price of the stock is high in relation to the earnings and possibly, it is overvalued.
4. Return on Capital Employed Method:- Return on Capital Employed is a type of profitability ratio and is calculated through dividing Earning Before Interest and Tax (EBIT), by capital employed. Capital Employed is the difference between total assets and current liabilities. It measures how efficiently a company is using its capital to generate profits. If the value of this ratio is high, it shows that a large amount of profits can be invested back in the company for the benefit of all the shareholders.
5. Fair Value Method:- Firstly, under this method, the profit is calculated on the basis of past average profit, and then the capitalised value of profit is calculated on the basis of Normal Rate of Return. Finally, the capitalised value of profit is divided by the number of shares to find the value of each share.
6. Discounted Cash Flow Method:- This is a method of valuation that is used to determine the value of investment which is based on it’s return or future expected cash flows. The return of investment must be greater than the Weighted Average Cost of Capital (WACC).
BENEFITS
Following are the benefits of Valuation of Shares:-
1. It Helps to Identify Risk Areas of the company and proper precautions can be taken to avoid such shares that are dangerous for the portfolio.
2. Analysis of Stock can be done easily after its valuation.
3. Comparative Analysis within the sector and industry becomes easier.
4. Impact of Corporate Events, such as Acquisitions, Mergers, etc., can be assessed easily using stock valuation as these events may affect future cash flows and value of share of the company.
DISADVANTAGES
Following are some disadvantages of Valuation of Shares:-
1. Occurrence of Faults in Assumptions that are taken during the valuation process. These assumptions frequently go wrong since these are based on estimates. In case, if the assumptions go wrong, the value of shares can be affected by which wrong decisions will be taken by the management.
2. Intangible Assets are not considered during the valuation of shares which shall result in wrong investment decisions.