ASSIGNMENT - VALUATION OF SHARE

WEALTH MANAGEMENT

ASSIGNMENT ON METHODS OF VALUATION OF SHARES

SUBMITTED BY: GARIMA JOSHI 11BSP1415

ASSIGNMENT - VALUATION OF SHARE

BACKGROUND
Valuation of share is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally potential market prices, and thus to profit from price movement stocks that are judged undervalued with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall.

INTRODUCTION
The valuation of the shares of a company involves use of judgement, experience and knowledge. The accountant undertaking this work should possess knowledge of the analysis and interpretation of financial statements backed by a practical appreciation of business affairs and investments. A valuation based on quantitative information alone will not be adequate for a real valuation. It should also be recognised that the method of valuation of shares would vary, depending on the purpose for which it is to be used. A clear understanding of the purpose of valuation is undoubtedly important, but an equally important imperative is to have a full appreciation of the value emanating from common principles. This general purpose value may be suitably modified for the special purpose for which the valuation is done. The factors affecting that value with reference to the special purpose must be judged and brought into final assessment in a sound and reasonable manner. The following is an illustrative list of the circumstances which call for a value to be placed upon shares in companies: Sale of shares by a person to another. Merger of two or more companies or the absorption of one company by another or in a capital restructuring exercise. Tax purposes, acquisitions/transfers etc.

ASSIGNMENT - VALUATION OF SHARE

METHODS OF VALUATION OF SHARES

The most theoretically sound share valuation approaches are as follows:

INCOME APPROACH
The income approach includes a number of models/ techniques, such as Discounted Cash Flow, Maintainable Profits Basis, Dividend Discount Model, and others, which are discussed in detail in the following paragraphs. DISCOUNTED CASH FLOW Discounted Cash Flow model indicates the fair market value of a business based on the value of cash flows that the business is expected to generate in future. This method involves the estimation of post-tax cash flows for the projected period, after taking into account the businesss requirement of reinvestment in terms of capital expenditure and incremental working capital. These cash flows are then discounted at a cost of capital that reflects the risks of the business and the capital structure of the entity. ADVANTAGES: a. Theoretically, it is a very sound model because it is based upon expected future cash flows of a company that will determine an investors actual return. b. It is based on expectations of performance specific to the business, and is not influenced by short-term market conditions or non-economic indicators. c. It is not as vulnerable to accounting conventions like depreciation, inventory valuation in comparison with the other techniques/approaches since it is based on cash flows rather than accounting profits. d. It is appropriate for valuing green-field or start-up projects, as these projects have little or no asset base or earnings which render the net asset or multiple approaches inappropriate. However, it is important that valuation must recognise the additional risks in such a case (e.g. project execution risks, lack of past track record, etc.) by using an appropriate discount rate.

ASSIGNMENT - VALUATION OF SHARE

SHORTCOMINGS a. It is only as good as its input assumptions. Following the garbage in, garbage out principle, if the inputs Cash Flow Projections, Discount Rate, and Terminal Value are wide off the mark, then the value generated by using this model does not reflect the fair value. b. It does not take into account several other factors, such as investment risk associated with opportunity cost, i.e. investments that could return greater cash flow yields would add an unrealised element of risk, unforeseen variations in future cash flow, and other non-financial factors. MAINTAINABLE PROFITS In this method a reasonable estimate of the average future maintainable profits is made by considering past earnings, their trend and future plans of the company. The estimated average future maintainable profit after deducting the preferred rights, if any, is capitalised at an appropriately selected rate to arrive at the value of the equity. This approach to valuation of shares needs the determination Of two factors, viz. (1)Average future maintainable profits (2)The rate of capitalisation. DIVIDEND DISCOUNT MODEL It is the simplest model for valuing equity. It equals the value of a share to the present value of dividends expected to be received. It works similar to the discounted cash flow model. Two basic ingredients of the model are expected dividends and the cost of equity. To estimate dividends, assumptions about expected future growth rates in earnings and payout ratios have to be made. The required rate of return on a share is determined by its riskiness. This model is not used in most practical situations as dividends may not reflect the true profitability of a business and payout is a management decision. Accordingly, this model suffers from a number of issues like forecasting of dividend pay-outs, non-applicability of the model to nondividend paying companies, retention of profits for capital expenditure, etc.

ASSIGNMENT - VALUATION OF SHARE

MARKET APPROACH
Compared to the income approach that provides a company specific and intrinsic value, market approach or relative valuation aims to provide the value of a business, based upon how similar assets are priced in the market. The use of relative valuation is widespread, especially in equity research reports and acquisition valuations. It provides a reasonable basis for valuation and is relatively a quick approach, ADVANTAGES a. It incorporates information from other valuations in a simple way and provides consistency in the valuation process by ensuring that valuation is in line with other valuations. b. It allows free-ride on markets information and embodies market consensus about discount rate and growth rate. Hence, it reflects the current mood of the market. c. It is simple and easy to use. It is also less time consuming. DISADVANTAGES a. Relative valuation is as good as the valuation of the comparable companies and suffers from volatility of the market. For example, in case the market is overvaluing comparable companies, the relative valuation will also lead to overstatement of value. b. Identifying comparable companies with similar growth rates, business composition, stage and riskiness of business is a difficult task and finding a perfect match is almost impossible. Adjusting the multiples for company-specific information is subjective and, thus, debatable. c. Differences in accounting policies related to revenue recognition, depreciation, etc., though adjustable to a certain extent, can result in a distorted valuation. d. Relative valuation is generally based on past data and results in the undervaluation of a company with a significant potential or benefiting circumstance like market expansion. One of the methods used in Market Approach is Market Comparable Method.

ASSIGNMENT - VALUATION OF SHARE

MARKET COMPARABLE METHOD Market Comparable Method involves identification of comparable companies, and derivation and application of multiples after adjustment of differences in fundamentals. Theoretically, a comparable company is the one with cash flows, growth potential and risk similar to the company being valued. Conventionally, looking at the companies within the sector provides a better-matched and similar-profiled set of comparable companies. Alternatively, in some cases, it is necessary to look across sectors to identify comparable companies. In practice, one hardly finds exactly similar companies. The next step is to arrive at a standardised set of ratios for comparison, commonly known as multiples. Multiples are a ratio of the enterprise value/equity value over different financial parameters like Revenue, Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA), Profit after Tax (PAT), Earnings per Share (EPS), book value, etc., with some being preferred over the others. For example, EBITDA multiple is preferred over PAT multiple so as to eliminate the effect of differences in depreciation policies and the impact of leveraging.

NET ASSETS APPROACH

Valuation of shares on asset basis attempts to measure the value of the net assets of a company against each share. It is computed by taking the net value of a companys assets, subtracting there from the amount of the liabilities and preferred share-holders claims and dividing the remainder among the equity shareholders according to their individual rights. Asset basis has to be used for valuation for certain specific purposes, e.g., special provisions of various tax laws. It may be appropriate to value shares on asset basis under many other circumstances, the more important of which are mentioned below: a. In cases where there is paucity of information about profits that would serve as a basis of valuing shares, such as: (i) In case of new companies whose accounts do not serve as a guide to future profits. (ii) Where a company has been trading at a loss and there are no prospects of earning any profit in the near future. (iii) In case of companies where there is no reliable evidence of future profits due to violent fluctuations in business, or disruption in business.

ASSIGNMENT - VALUATION OF SHARE

b. Other circumstances, such as, when it is intended to liquidate the company and to realise the assets and distribute the net proceeds among shareholders. Assets value also becomes a material factor in valuation of shares where assets are surplus to existing business operations, e.g., excess land in a manufacturing company.

VALUATION OF STOCK BASED ON FUNDAMENTAL ANALYSIS

The fundamental valuation is the valuation that people use to justify stock prices. This form of valuation is based on historic ratios and statistics and aims to assign value to a stock based on measurable attributes. This form of valuation is typically what drives long-term stock prices. Methods based on fundamental analysis are as follows: EARNINGS PER SHARE EPS is the total net income of the company divided by the number of shares outstanding. They usually have a GAAP EPS number (which means that it is computed using all of mutually agreed upon accounting rules) and a Pro Forma EPS figure (which means that they have adjusted the income to exclude any one time items as well as some non-cash items like amortization of goodwill or stock option expenses). The most important thing to look for in the EPS figure is the overall quality of earnings The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net income that excludes any one-time gains or losses and excludes any non-cash expenses like stock options or amortization of goodwill. Then divide this number by the number of fully diluted shares outstanding. PRICE TO EARNINGS The price to earnings ratio is the ratio of stock price and the annual EPS figure. For example, if the stock is trading at $10 and the EPS is $0.50, the P/E is 20 times. To get a good feeling of what P/E multiple a stock trades at, be sure to look at the historical and forward ratios. Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four quarters, or for the previous year. You should also look at the historical trends of the P/E by viewing a chart of its historical P/E over the last several years. Specifically you want to find out what range the P/E has traded in so that you can determine if the current P/E is high or low versus its historical average. Forward P/Es reflect the future growth of the company into the figure. Forward P/Es are computed by taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for the EPS estimate for next calendar of fiscal year or two.

ASSIGNMENT - VALUATION OF SHARE

P/Es change constantly. If there is a large price change in a stock you are watching, or if the earnings (EPS) estimates change, the ratio is recomputed. GROWTH RATE Valuations rely very heavily on the expected growth rate of a company. One must look at the historical growth rate of both sales and income to get a feeling for the type of future growth expected. However, companies are constantly changing, as well as the economy, so solely using historical growth rates to predict the future is not an acceptable form of valuation. Instead, they are used as guidelines for what future growth could look like if similar circumstances are encountered by the company. Calculating the future growth rate requires personal investment research. This may take form in listening to the company's quarterly conference call or reading press release or other company article that discusses the company's growth guidance. However, although companies are in the best position to forecast their own growth, they are far from accurate, and unforeseen events could cause rapid changes in the economy and in the company's industry. And for any valuation technique, it's important to look at a range of forecast values. For example, if the company being valued has been growing earnings between 5 and 10% each year for the last 5 years, but believes that it will grow 15 - 20% this year, a more conservative growth rate of 10 - 15% would be appropriate in valuations. Another example would be for a company that has been going through restructuring. They may have been growing earnings at 10 - 15% over the past several quarters / years because of cost cutting, but their sales growth could be only 0 - 5%. This would signal that their earnings growth will probably slow when the cost cutting has fully taken effect. Therefore, forecasting an earnings growth closer to the 0 - 5% rate would be more appropriate rather than the 15 - 20%. PRICE EARNINGS TO GROWTH (PEG) RATIO This method is better than just looking at a P/E because it takes three factors into account; the price, earnings, and earnings growth rates. To compute the PEG ratio, divide the Forward P/E by the expected earnings growth rate (you can also use historical P/E and historical growth rate to see where it's traded in the past). This will yield a ratio that is usually expressed as a percentage. The theory goes that as the percentage rises over 100% the stock becomes more and more overvalued, and as the PEG ratio falls below 100% the stock becomes more and more undervalued. The theory is based on a belief that P/E ratios should approximate the long-term growth rate of a company's earnings. Whether or not this is true will never be proven and the theory is therefore just a rule of thumb to use in the overall valuation process. Here's an example of how to use the PEG ratio. Say you are comparing two stocks that you are thinking about buying. Stock A is trading at a forward

ASSIGNMENT - VALUATION OF SHARE

P/E of 15 and expected to grow at 20%. Stock B is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A is 75% (15/20) and for Stock B is 120% (30/25). According to the PEG ratio, Stock A is a better purchase because it has a lower PEG ratio, or in other words, you can purchase its future earnings growth for a lower relative price than that of Stock B.

VALUATION OF SHARE IN WEALTH MANAGEMENT

Measuring Return: One other most important aspect in allocation of asset is to understand the expected return on the security or share. Valuation of share helps us in calculating the return and comparing the same with desire return. Risk Associated with Share: Before investing in any share, one should know the risk associated with it. Valuation method help us in knowing the risk associated with share in term of 'beta'. These risks could be diversified or non-diversified. True Value Of Share: A share can be over priced or under-price in Stock Market. This could be because of various outlooks on the security. If the share is under-priced, investor will go with it. For Example: If the market price of share is Rs 100 and as per the valuation of share, its intrinsic value comes to Rs 120. It means the share in under-priced in Market by Rs 20. Correlation In Portfolio: It is said that, there should be negative correlation between various securities in portfolio. So that if security is not performing other will offset the negative return with higher return. Finding the correlation between various securities is a part of Valuation of security. True Value of Investment: We can calculate true value of investment made in various securities. It helps us to calculated total risk, return and correlation of portfolio.

ASSIGNMENT - VALUATION OF SHARE

CONCLUSION
a. Selection of an appropriate approach Income, Market, or Net Assets as well as the technique/model within the selected approach by a valuer is dependent on the facts and circumstances of the case. In practice, however, a combination of all the approaches is used by assigning appropriate weightage to each approach. b. The appropriateness of any approach and also the weightage assigned to each approach in case of a combination of two or more approaches used has been the subject of a number of litigations and deliberations. Various judicial pronouncements have upheld the valuation based on a combination of two or more approaches.

10