Valuation of Shares

Last Updated : May 18, 2023, 11 a.m.

The valuation of shares is not completely similar to the share prices. It is a procedure to determine the fair value of a company’s share in the stock market, while the demand and supply forces usually determine the latter. If a company’s demand is high, there is a fair chance that the share price will go up. It does not reflect the true value or fair value of a share. You can find the company’s true or intrinsic value by using the company’s financial information or by analysing the company’s share valuation.

Defining Share Valuation

Share valuation is a process of determining the actual value of a company’s share. The valuation of shares is calculated based on quantitative techniques. The examiner uses a company’s financial information, like actual earnings, cash flow statements, balance sheets, assets, future cash flow, etc. By doing so, the examiner gets an idea about the company’s intrinsic value and whether the company is undervalued or overvalued.

An undervalued company can be identified when the company’s intrinsic value is higher than the market price. On the other hand, an overvalued company can be identified when the intrinsic value is lower than the market price.

Therefore, undervalued shares are considered a good investment source for the value investor and the one who practices value investing.

Value investing is nothing but the investment in the value where the intrinsic price is higher than the market price.

When is the Valuation of Shares Required?

Given below are the situations when the valuation of shares plays a significant role.

• An owner who wants to know the business value to sell his company at the best possible price performs share valuation.
• Mergers, acquisitions, takeovers, reconstruction, amalgamation, etc., require the valuation of shares.
• A bank requires the valuation of shares to grant a loan against the shares for security.
• You can apply one of the methods of valuation of shares when your company’s preference shares are to be converted to equity shares.
• Valuation is needed when establishing an Employee Stock Ownership Plan (ESOP).
• During a tax audit, the valuation of shares is required.
• When a company faces litigation, the valuation of shares is required.
• Investors evaluate the share price before investing because the market price may not show the actual picture of the shares.

Types of Stock Valuation

There are two approaches to determining intrinsic value: Absolute and Relative

Absolute Valuation

Absolute valuation involves using a company’s finances and fundamentals to calculate its intrinsic value. It is done by analysing past financial data, including cashflows, growth and dividends, to evaluate future cash flows and assign them a value. It only uses its own company’s financial data to calculate the intrinsic value. It does not involve any other companies’ financial data. Absolute valuation also includes discounted cash flows, dividend discount models and asset-based models.

Relative Valuation

Relative valuation compares the financial data of similar companies. Comparison is made between similar companies; the company is valued based on the P/E ratio, i.e., price v/s earnings and dividend yield. With this comparison, it is concluded whether the company is undervalued or overvalued. When the P/E ratio is lower than the peers, it is considered undervalued, whereas if the company has a higher P/E ratio than the peers, it is considered overvalued. Relative valuation also includes the P/E ratio, the price-to-book value (P/B), and enterprise multiple (EV/EBITDA).

Methods Used for the Valuation of Shares

Different methods of valuation of shares used by analysts and investors are discussed below.

Dividend Discount Model

The model is one of the simplest methods to determine the share valuation. It only uses dividends to calculate the company’s intrinsic value because it is the only cash flow towards shareholders.

The company’s actual value can be determined by determining the present value of all future cash flows.

Asset-based Model

The asset-based model involves the company’s assets and liabilities. It first examines the net assets value to determine the share value. The following formula can mathematically calculate the value per share.

Value per share= (Net Assets – preference capital)/ Number of equity shares

This formula applies to big manufacturing companies having huge assets.

Discounted Cash Flow (DCF)

The discounted cash flow DCF method involves an income-based approach to evaluate shares. This technique value company of different size and industry. It attempts to investigate the future cash flows based on which today’s value is generated. It helps to find out how much money an investment will generate in the future.

Price to Earnings (P/E) Ratio

It is a relative valuation technique to value companies of the same size and industry. It tells the amount willing to pay by an investor for every Rs. 1 of earnings. It is considered undervalued if the P/E ratio is high and considered overvalued if the P/E ratio is low.

Price to Book Value (P/B) Ratio

It is also a relative valuation technique of market value against book value. Book value is considered to be the net difference between that company’s total assets and total liabilities. Even this valuation method can be used to determine how the company is valued. If the P/B ratio is below one, it is considered a good P/B ratio.

EV/EBITDA

It is also known as enterprise multiple or EV multiples. It is a relative valuation of the company’s enterprise value (EV) to its Earning Before In Taxes, Depreciation & Amortisation. It’s a technique to compare the value of different businesses.

Note that choosing the best stock methods of valuation of shares depends on the company and industry.

Factors Affecting the Valuation of Shares

Company’s financials: Factors such as profits, cash flows, dividends and assets affect the shares’ valuation.

• Market Price: It is one of the important factors in the case of relative valuation. P/E and P/B use market price to calculate the valuation of shares.
• Economic Conditions: This is one of the most unpredictable criteria which can affect the valuation of shares. In a recessionary environment, with inflation, high-interest rates, low demand etc., the valuation of shares changes in the short term.

Conclusion

Valuation of shares plays a vital role to the trader or a long-term investor by calculating a company’s fair value. It is necessary to acquire knowledge of different methods of share valuations as per the requirements.

FAQs