Valuation of shares
By Taha Popatia
Valuation is just a guide for buyer and seller about the company’s value. The final purchase / sale price will be
decided between buyer and seller.
Basic methods of valuation are
1. Net Assets Based Valuation
− Balance sheet basis (book value)
− Net realizable value basis (disposal value of assets)
− Replacement basis (cost of acquisition at open market)
2. Price / Earnings ratio method
3. Earnings yield method
4. Dividend yield method
5. Dividend valuation method
6. Cash flow method / Free cash flow method (present value of cash flows)
Reasons for valuation
1. Takeover bid , for bidder to decide the offer price
2. When a company wants to get listed , to decide share issue price
3. At the time of merger of two companies
Net Assets Based Valuation Method
Generally used to value a business when the company is supposed to be broken up and sold. May be the
company is not profitable or we want some specific asset only. This is not normally the case.
Gives guide about the minimum value of the company. Somebody selling a loss making company will obviously
want you to pay for the minimum value of the assets less liabilities the company owns
Example # 1
Assets = 1,000, Liabilities = 500 and Number of shares = 100
Net Assets = 1.000 – 500 = 500 Book value per share = 500 / 100 = Rs. 5 per share
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Valuation of shares
By Taha Popatia
Price / Earnings ratio method
Price / Earnings ratio
− Used to determine how much investors are willing to pay for a stock relative to the company’s earnings
− High p/e suggest good future prospects for the company.
Example # 2
Company’s current share price is Rs. 240
Company’s current EPS is Rs. 80
Therefore Price Earnings ratio is 3
Company’s future EPS is expected to be Rs. 120
Using Market value per share = EPS X P/E ratio = 120 X 3 = 360
The main weaknesses of P/E valuations are:
• They are based on accounting profits (subject to estimates etc. different accounting policies) rather than cash
flows;
• It is difficult to identify a suitable P/E ratio, particularly when valuing the shares of an unlisted entity;
For unquoted company: we will adjusted the price earnings ratio of a similar (same industry) quoted company by
1/3rd or simply take 2/3rd of the price earnings ratio of a similar quoted company. Exam questions may test this
adjustment factor.
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Valuation of shares
By Taha Popatia
We can use target company’s eps and our own P/E ratio to reflect the fact that once we buy the target company
we will enhance its performance.
If the target company operates in the same industry as we do, we can use our own P/E ratio. If it operates in any
other industry we will use that industry’s P/E ratio.
The EPS of Target Company may be adjusted for planned changes for example, after purchase we may remove
some senior management therefore reducing our costs.
Buying smaller company is more risky therefore we may adjust our P/E ratio to reflect this fact.
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Valuation of shares
By Taha Popatia
Can we use average sector price earnings ratio for calculation of market price?
Yes average sector price earnings ratio may be used. This is possible when one company intends to acquire
another company and the company placing bid is confident that it will be able to improve the financial
performance of Target Company after acquisition ( refer Question 1 in questions handout)
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Valuation of shares
By Taha Popatia
Earning yield method
- We discount future earnings using an appropriate earnings yield as a discount rate
- We can incorporate earnings growth into this method
- Used when we have majority stake ( majority shareholding , only in that case we can decide how to use
earnings – whether to distribute it as dividend or reinvest to generate higher returns in future years
Dividend valuation model
- Where we have minority stake, if we have only minority holding in a company we cannot control
company’s earnings. Therefore the only return is the dividend flow
- Present value of all future income streams in the form of dividend
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Valuation of shares
By Taha Popatia
Do is current years dividend , g is growth rate . ke is shareholders required rate of return
is actually dividend after one year
Ke may be calculated by CAPM
For calculation of growth
We may use
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Valuation of shares
By Taha Popatia
Past growth trend or Gordon’s growth model
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