BASES OF SHARE VALUATION

Share valuation can be done on the basis of income and asset values.  However, on the basis of income a share will be entitled to two forms of income.  For this reason the bases of valuing shares are:

i)    Earnings method
ii)    Dividend method
iii)    Assets method

I) Earnings Method (Or Earning Basis Valuation)
Using the earning valuation method, a company will use its P/E ratio to value its shares.

P/E    =    MV
E

MV    =    E x P/E -> value of ordinary share.

The MV can be determined where the estimated earnings have been established by applying the P/E ratio expected of this type of company.

Example
Company XYZ is expected to generate post tax earnings of Sh.200,000 per annum and companies in the same trade will generally have a P/E ratio of eight (8).  On account of company XYZ limited size, a ratio of six (6) is considered more appropriate.  The issued share capital is 1,000,000ordinary shares of Sh.50 each.

Required
Value of shares    =    EPS x P/E

=    Earnings per share x P/E

=       200,000 x 6 = Sh.12.00
1,000,000

Value of Business    =    Earnings x P/E ratio

MV    =    E x P/E = Sh.200,000 x 6 = Sh.1.2 million

ii) Dividend Basis Valuation
Ownership of shares in entities – The owner to receive a cash flow consisting of future dividends and the value of a share should correspond to the present value of this future cash flow.  A shareholder cannot expect cash flows in perpetuity as he will sell his shares at one time.

Po =     Do
Ke

Note:    Where there is growth in equity,    P0    =

Example
Company XYZ pays a dividend of 10% on its Sh.60 par value ordinary shares.  This company uses a discount rate of 15%.  Assuming no growth, compute the value of its ordinary share if there’s growth of 5%, what would be the value of this company’s ordinary shares.

a)    Po =     Do        Po =      6   = Sh.40    (no growth)                        Ke            15%

b)    Po =    6(1.05)         =    Shs.63 (5% growth rate)
0.15-0.05

iii) Asset Based Valuation
This method takes into account the entire business with reference to its assets and then divides the resultant value by the number of shares in an issue to give the per share.  The principles are the same as those in the valuation of businesses computed already.  However, if a historical dividend based on earning based valuation produces a figure which is less than the asset value then there is a possibility that the buyer may be able to improve the management of the asset being taken over.  In such a case, a buyer would be prepared to pay a price which though excessive in terms of income might be justified by the underlying assets value.

Example 1
Information extracted from the books of Kent Limited.

Current liabilities
Bank overdraft
Sh.
300,000
50,000
350,000

Land
Sh.
250,000
100,000
350,000

Stock has a realisable value of Sh.80,000 and land Sh.300,000.  This company is assumed to be have a share capital of 20,000 ordinary shares.

Compute the value of its shares.

i)    Assets method

Assets = L & B         300,000
Stock           80,000
380,000
Liabilities        [350,000]
30,000

Value of shares    =    30,000    =    Sh.1.50
20,000

Example 2
K & K Company Limited is planning to absorb three other companies so as to realise its sales records of Sh.500,000 per annum.  Its accountants have advised the company to maintain such a size that it will enable its shares to sell at a minimum price of Sh.16.  The company’s last published balance sheets indicate the following:

Sh.’000’
Ordinary shares of Sh.10 each          50,000
Reserves                  65,000
Current liabilities              40,000
Total                    155,000

Assets:                    Sh.
Fixed assets                  80,000
Current assets                  75,000
Total                    155,000

Profits for the last 5 years were as follows:

Sh.’000’
1.      9,000
2.      6,000
3.    10,000
4.      8,000
5.    17,000

P/E ratio applicable is 12:1

Compute the value of the business indicating the lowest offer price and the highest offer price and the share value thereof whether it would be viable to take on the three companies if its to maintain this share value.

P/E RATIO METHOD

P/E = 12:1    Average profits        = 10,000,000

Therefore Value of business        = 10,000,000 x 12    =    Sh.120,000,000

Value of shares    =    Sh.120 million    = Sh.24
5 million shares

ASSETS METHOD
Sh.’000’
Assets                155,000
Less: Current liabilities        [ 40,000]
115,000

Value of shares        =    Sh.115M = Sh.23
5M shares

Where:    Po = Price of ordinary shares
d   = Dividend at the end of year one
P1 = Price of the share at the end of one year.