Valuation Techniques – 3 Methods of Valuation of Securities, Shares, Stocks, and Debentures.
The methods of security valuation can be considered under three main heads viz.,
- Those that are based on physical assets,
- Those that emphasize earning power, and
- Those that stress actual or imputed market prices.
There is no single reliable method of determining the value of an enterprise or its securities that can be applied to all situations. Often several methods or various combinations of methods are useful in a particular situation. It is worth noting that the purpose of the particular valuation and the point of view of the evaluator strongly influence the selection of approach to or method of valuation.
The followings are the aforesaid three methods of valuation of securities, shares, stocks, and debentures generally used by financial analysts.
Asset Approaches to Valuation
The valuation of securities is often determined on the basis of the value of assets. The value of assets is determined on the basis of three approaches which are discussed below:
Book value or Break-up value:
Book value is determined by the asset value shown on the company’s balance sheet. The excess of assets over debt represents the net worth of the business in the accounting terminology and provides the base for the calculation of the book value. If a company has got outstanding preference shares, value for these shares is deducted to determine the net worth application to ordinary shares. The net worth available to ordinary shares divided by the number of outstanding ordinary shares gives book value per share. The major weaknesses of this method of valuation are given below:
▪ First, figures for book value are influenced by the accounting practices and policies of an enterprise.
▪ Secondly, there is a lack of standardization of accounting practices in the treatment of intangibles like goodwill and patents.
▪ Thirdly, analysts face the difficult job of reconstructing reported figures in valuing the security of one company against that of another in order to get them on a comparable basis.
▪ Fourthly, a concern following financial accounting practices will arrive at the value by reference to conventions rather than sheer logic of value.
▪ Finally, the book value approach does give proper consideration to the earning power of the assets which may be the real test of their worth.
Realizable or liquidation value:
The value of individual assets that can be had by selling them. Such value is known as the realizable or liquidation value. The liquidation value can be estimated for the company as a whole means the estimated net amounts that will be received by the sale of assets less any liabilities. The liquidation value of a company is usually less than its economic value as a going concern. It has significance in bargaining on valuation because it represents a minimum price. A company should not be sold as a unit for less than its liquidation value. When earnings in a company are nonexistent, liquidation value may become significant.
Replacement or reproduction value:
To avoid the problem of changing price levels it is often suggested that assets should be valued on the basis of replacement cost rather than historical cost. Replacement cost is estimated by competent engineering authorities by breaking down property into its various component units for the purpose of detailed examination. Such valuation has much significance as expert opinion, but the conclusions are not universally accepted. The major problems arising in this method of valuation are mentioned below:
▪ First, it is often difficult to estimate the costs of replacement.
▪ Secondly, there remains the problem of determining depreciation on the replacement costs.
▪ Thirdly, While costs of replacing physical assets can be calculated by a painstaking appraisal, the cost of duplicating the business organization, its experience, know-how, and reputation-apart from the physical assets is the most difficult to determine.
▪ Finally, the estimate of replacement cost does not measure the value of assets in use.
Capitalization of Earnings Approach
The capitalization of the earnings approach for the valuation of ordinary shares is based on the philosophy that the current value of the property depends on the income which can be had over the years. This approach is based on the feeling that it is the earning power that provides income to the shareholders and it income that they value rather than physical assets. The basic validity of this approach is rarely challenged. However, problems do arise in the application of this approach to actual situations.
There are three basic steps involved in the method of valuation: determination of earnings, determination of the rate of capitalization and capitalizing the value of earnings.
Determination of earnings:
In determining future earning power one has to consider the corporate earnings’ past record and the first step to get this record as straight as possible. There are difficulties in getting reliable data and the person making the valuation may not have access to all the data he would like. The difficulty is also created due to the varied character of accounting practices which may require a number of adjustments for converting earnings data to a basis appropriate for the comparison. In practice, an estimate of future earnings is prepared over an arbitrary time horizon which would be a period short enough to justify a reasonable degree of confidence in the expected earnings. The significant consideration is the selection of a period of time which represents a normal picture of both the good and bad years in the company’s recent history. It should be a period covering the completion of the business cycle so those poor years are averaged with the good.
Thus, in assessing future earning power one has to pay due attention to the record of earnings of the enterprise in the past, nature, and context of competition in the industry, treatment of research and development expenditures, the general economic conditions and government policies of trade, tariff, taxation, money, and banking, etc. In fact, one has to determine maintainable profits for the future. There are three approaches to the determination of maintainable profits: i) a simple average may be calculated in case of established industry with no growth prospects, ii) weighted average has to be calculated in case of established industry with no growth prospects and iii) projected average has to be calculated in case of industries having growth potential.
Rate of capitalization:
After determining the annual earning rate for the enterprise as a whole or per share, the next step is to apply a capitalization rate to arrive at the prospective investment value. The capitalization rate is no more than an earning price ratio, i.e., it is the ratio of earnings to price. In general, the selection of this rate of capitalization is affected by the following considerations:
- Prevailing interest rates,
- The risk involved in the industry,
- The time required for reaching capacity production in the enterprise,
- Nature, magnitude and potentiality of competition.
Capitalization of earnings:
The process of putting a valuation on the estimated earnings is known as the capitalization of earnings. As seen earlier, the process of estimating future earnings is an inexact one. Similarly, the selection of the appropriate rate of capitalization is mainly subjective. Some adjustments in the capitalized value of income become necessary. If some of the assets purchased have not contributed to the operating income, they can be sold without affecting the normal operating income. There may be excessive amounts of cash, inventories, and other assets on hand. The fair market value of these assets should be added to the capitalized value of earnings. On the other hand, it may be necessary to put additional sums to operate the assets effectively. Future earnings of a small manufacturing concern may depend upon the purchase of additional pieces of machinery or patent rights. Such payments made in order to obtain the estimated normal net income should be subtracted from the value of assets calculated by the capitalization of income. Valuation Techniques.
For capitalizing the earnings or maintainable profits at the capitalization rate the followings are the usual treatments:
Treatment-1: Capitalize maintainable profits at the capitalization rate related to the industry or business.
Treatment-2: Maintainable profits are arrived at after deducting taxes, preference dividend and normal plow back. After these deductions, the remaining profits are capitalized at the estimated capitalization rate.
Treatment-3: If the enterprise has surplus funds invested in outside shares or securities or redundant assets not helping in the normal earnings capacity of the enterprise, in that case, additions will be made to the capitalized value of earnings for the value of such redundant investments and assets.
Treatment-4: If the enterprise has a highly geared financial structure, i.e., high debt to equity ratio, the plow back is suitably increased and the rate for capitalizing the earnings also requires suitable adjustments. Financial leverage may add to earnings per share but it also increases the volatility of these earnings.
Advocates of this approach argue that actual market prices are appraisals of knowledgeable buyers and sellers who are willing to support their opinions with cash. Hence, the prices at which transactions take place are practical expressions of value which should be preferred to theoretical views or valuation. The market value of the share is in the nature of the “bloodless verdict of the market place”. Supporters of market price argue that it is determined by investors’ valuation of expected future earnings and thus reflects the value of the security.
Moreover, the market price is a definite measure that can readily be applied to a particular situation and it minimizes the subjectivity of other approaches in favor of a known yardstick of value.
The market price is a highly fluctuating quantity. In fact, the fluctuation may be so violent and extreme that one may question the validity of using the market price of the securities as a basis for exchange. However, in spite of this shortcoming, it is given much consideration, primarily due to its wide acceptance. The problems in using market price can be analyzed as follows:
First, market quotations are not available for a large number of enterprises whose shares are not listed on the exchanges.
Secondly, even for those enterprises whose shares are listed there may not be active trading.
Thirdly, the release of a relatively small number of shares on a thin market may be enough to depress market prices substantially.
Fourthly, the market price for a particular share on a given date may be influenced by artificial means like the cornering of shares.
Fifthly, sales of shares in a closely held enterprise may not reflect fair market prices.
Finally, it is difficult to sell whether movements on the price of a share in response to rumors cause the price to move upwards or away from its economic value.
To meet some of the objectives noted above, the theory of fair market value has been developed. Fair market value is based on the assumption that there are willing buyers and willing sellers actually in the market, each well-informed and prepared to act in an entirely rational manner. This approach meets to a greater extent most of the objections against market price.
Valuation Techniques – 3 Methods of Valuation of Securities, Shares, Stocks, and Debentures