This article is written by Pranav Sethi, from SVKM NMIMS School of law, Navi Mumbai. This article analyzes the valuation of shares.
Table of Contents
Introduction
Till the initiation of the Companies Act, 2013, the valuation of a company’s shares, assets, and net worth was done by chartered accountants or as mandated by other laws such as the Foreign Exchange Management Act, 1999 and the provisions made thereunder, or the Income Tax Act, 1961. No requirement in the previous company law offered for valuation or defined who could perform the valuation of companies, shares, or other assets.
At the preliminary stage, company valuation should be market-oriented, as an investor is willing to invest and a company expected to grow. The dialogue between them should serve as a guide. This argument, even so, is strictly regulated, and the valuation must be demonstrated to the fulfilment of the tax officers.
Section 247 of Chapter XVII of the Indian Companies Act established the notion of a “registered valuer” for the very first time in Indian law for seeking appropriate valuation there under said Act.
Section 247 of the Companies Act explains that “where a valuation is required to be made in respect of any property, stocks, shares, debentures, securities or goodwill or any other asset or net worth of a company or its liabilities under the provisions of this Act, it shall be valued by a person having such qualifications and experience and registered as a valuer in such manner and on such terms and conditions as may be prescribed and appointed by the audit committee or in its absence by the Board of Directors of that company”.
Some key points for a registered valuer
It is worth noting that, according to Section 247(2) of the Companies Act, the registered valuer must:
- Make an independent and objective, true, and fair valuation of any assets that may need to be prized;
- When executing the duties of a valuer, exercise caution;
- Make the valuation to comply with any rules that may be established; and
- He shall not undertake the valuation of any assets in which he has a direct or indirect interest or it becomes so at any time during or after the valuation of assets.
What exactly is share valuation?
The system of determining the value of a company’s shares is known as share valuation. Share valuation is performed using quantitative techniques, and share values vary according to market demand and supply. The share price of publicly traded listed companies is readily available. However, in the case of private companies whose shares are not publicly traded, share valuation is extremely complex and vital.
When is a share valuation needed?
Some of the situations in which share valuation is significant are as follows:
- Merger, acquisition, reconstruction, amalgamation, and other similar transactions necessitate the valuation of shares.
- One significant possible explanation is when you are about to sell your business and want to know how much it is worth.
- When enforcing an employee stock ownership plan (ESOP), valuation is needed.
- When you encounter your bank for a loan with shares as collateral.
- When the shares of your company are to be changed, i.e. from preference to equity.
- In the event of a lawsuit where share valuation is lawfully bound.
- For tax assessments that are under the act on the wealth tax or the gift tax.
Even publicly traded shares must also be recognized because market quotations do not always represent the current picture, or big volumes of shares are being transferred, and so on.
What are the different forms of stock valuation?
There are two kinds of share valuations based on the value obtained from the techniques used:
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Absolute valuation
Absolute valuation is the method utilized to determine the “intrinsic” value of the shares, as mentioned previously. The whole technique mainly focuses on the company’s fundamentals such as dividends, cash flow, and the rate of growth of the involved company.
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Relative valuation
The comparative valuation method, among others, employs ratio analysis to determine the value of a stock in contrast to its peer group.
How and when to select a share valuation method?
There are multiple justifications for using a specific method for valuing shares; it usually depends on the objective of valuation. Overall, using a variety of techniques yields a much more credible valuation. Following are the approaches for valuing shares:
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Assets approach
An asset-based framework could be used if a corporation is capital-intensive and has started investing a massive proportion in capital assets, or if the businesses have some capital work progress. This procedure can also be used to determine the value of a company’s shares during a merger, absorption, or liquidation.
This method is rooted in the NAV and shares the value of the company. The net asset value (NAV) of the company is divided by the number of shares to determine the value of each share.
A company’s net asset value is the difference between the net value of all of its financial assets. The determined net asset value must be limited by the total equity shares to discover the exact value of the share.
The following are among the key points to keep in mind when valuing stocks using this method
- Fixed assets must be valued at their realizable value.
- The valuation of goodwill as an intangible asset is critical to the method of calculating.
- All of the firm’s profits, such as current assets and current liabilities such as trade receipts and payments, regulations, and so on, must be viewed.
- Preliminary expenses, discounts on shares and debentures, accumulated losses, and other fictitious assets must be avoided.
Value per share = (Net Assets – Preference Share Capital) / (No. of Equity Shares)
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Income approach
This procedure is divided into two parts: Discounted Cash Flow (DCF) and Price Earning Capacity (PEC). The DCF method determines fair value by projecting future cash flows, and it can be used if this information is readily accessible. The PEC process is based on historical earnings, and if an entity has not been in business for a long time and has only recently begun operational activities, this procedure cannot be used.
This method concentrates on the anticipated advantages of the business investment, i.e., what the company produces in the long term. The value per share technique is an effective method under this framework. In this case, the value per share is calculated using the company’s profit that is obtainable for allocation to shareholders. Paying back reserves and taxes from net profit produces the whole profit.
To calculate the value per share such instructions must be followed
- Determine the amount of profit currently offered for dividend allocation from the corporation.
- Acquire the regular return on investment for the applicable industrial sector; and
- The capitalized value is calculated as (profit for distribution*100/rate of return).
- Simply divide this amount from the number of shares.
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Market approach
The market value of the shares is recognized for valuation here under the general framework This approach, however, is only workable for publicly traded companies whose share prices can be gained on the open market. If there is a group of collaborative corporations which are mentioned and involved in an equivalent corporation then the share public prices of such a corporation could also be used. Private company information can be acquired from a variety of proprietary databases obtainable in the business sector What is even more essential is how to choose comparable companies; there are numerous factors to consider, such as the nature and volume of the business, industry, size, financial condition of the comparable companies, transaction date, and so on.
While utilizing the yield procedure (yield is the required rate of return on investment), there are two options, which are described under:
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Dividend yield
Shares are priced using this technique based on the estimated dividend and the standard rate of return. The mentioned formula is used to determine the value per share:
Expected rate of dividend = (profit available for dividend/paid-up equity share capital) X 100
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Earnings yield
Shares are prized based on estimated earnings and the standard rate of return. The following equation is used to calculate the value per share under this method:
Expected Rate of earning = (profit after Tax/Equity share’s paid-up Value) X 100
Value per share = expected Rate of earning/Normal Rate Of return X Paid Up equity Value
Difficulties and alternatives with share valuation
The income method takes into evaluation the company’s expected future cash flows. It can be determined by using the DCF or discounted cash flow means of measuring a company’s fair value.
- If the current value is less than the current cost of the investment, the investment should be avoided.
- If the current value exceeds the current cost of the investment, the investment should be considered.
DCF considers assumptions predicated on previous data which may or may not be correct. The discount rates, or “r,” may not be the same throughout the time interval because they are impacted by market rates, debt-equity structure, and income tax considerations.
The asset method considers the CAPM, or Capital Asset Pricing Model, to ascertain how assets generate expansion of the business. The CAPM model’s goal is to measure the market value or fair value of a company’s equity (or total net asset value). It assesses the company’s worth based on its balance sheet.
Asset-Based Valuation = Fair Value of company’s total assets / Fair Value of company’s total Liabilities
It is challenging to find out the value of all of the firm’s assets, or even the market value differs significantly from holding values. The process of determining the fair value of a company’s assets can become complex or open to interpretation, and the value may be overstated or unpretentious. Both of these strategies have advantages and disadvantages.
As a consequence, several more experts adjust their suppositions as soon as the results are published, and as a result, they either cut the price target for the stock or tweak it for a greater return depending on the outcome.
Factors affecting the valuation of shares
The combinations utilized in the widely known strategies of share valuation are the primary variables influencing share valuation. These are some examples:
- The net earnings of the business;
- Cash flows and dividends of the business; and
- The normal rate of return of the industry.
The impact of these aspects is determined by whether they are used in the estimation of the share value.
EPS and P-E ratios share valuation effect
Earnings-per-share is the ratio of total earnings earned by the company to total shares exceptional. This parameter is used to calculate the P-E ratio, which is another common approach to valuing stocks. Simply put, the greater the EPS, the wealthier you are as a shareholder.
Let us now look at the P-E ratio.
The Price-to-Earnings Ratio compares the market price per share to the earnings per share. Whenever it relates to sharing valuation, a high P-E ratio may illustrate that a share’s price is high concerning its income and may be undervalued. On the other hand, a lesser P-E ratio may show that the average share price is lower with earnings. Several other important valuation ratios can influence our investment choices.
Case Laws
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M/s. Rameshwaram Strong Glass (P) Ltd. v The Income Tax Officer
In this case, the Income Tax Appellate Tribunal (ITAT) established the validity of the company that issued shares to choose another valuation research methods under the regulations of the Income Tax Act, 1961 (IT Act) read with the laws established hereinafter (Tax Law) for the means of assessing the ‘fair market value’ (FMV) of these shares at greater than the marginal. It managed to hold that the tax authorities cannot compel the taxpayer to modify its valuation method when the Tax Law allows the taxpayer to choose between the Net Asset Value (NAV) method and the Discounted Cash Flow (DCF) method.
According to Section 56(2)(viib) of the IT Act, when a privately held company issues shares at a premium to residents, if the price is higher than the value of the shares as determined by the valuation rules, the difference is taxed as “income from other sources in the hands of such corporation”.
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Innoviti Payment Solutions Pvt. Ltd. vs. ITO
In this case, the company authorized 10,42,658 shares at a premium of INR 23.50 per share with a face value of INR 10. A chartered accountant used the DFCF method to calculate the FMV.
The AO (assessing officer) rejected it, citing the accountant’s use of haze cash flow as accredited by the administration and the valuer’s failure to verify the predictions. It went on to say that the corporation will have ended in failure to provide the foundation for the forecasts and that managers had willfully disregarded variables including such efficiency, growth potential, earnings, and so on. The Bangalore Bench of the ITAT asserted that the profitability report’s estimates must be backed with sufficient assurance and that in the unavailability of such assistance, the valuation report is considered infeasible.
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Vodafone M Pesa Ltd. vs. PCIT
In this case, the Bombay High Court ordered that the AO does not have the legitimacy to deny the taxpayer’s existing valuation approach. It was legitimate that the AO has the authority to examine the valuation report and figure out certain computation errors, but not to force the taxpayer to use a distinct pricing model completely.
The Income Tax Rules, 1962 give the taxpayer the alternative of using either the DFCF or NAV method of valuation. As a result, the AO could not use his usual approach, particularly since Rule 11UA allows the taxpayer to select the method of valuation. As a result, clause (b) of Rule 11UA (2) would be rendered null and void.
Conclusion
Due to the respective rulings, it is possible to conclude that the financial regulators do not have the authority to order the taxpayer to use a specific method of valuation. According to the Income Tax Rules of 1962, the taxpayer can use the DFCF method or the NAV method for valuation. However, it should be noted that the taxpayer must be able to include credible information to substantiate the management-certified projections. Because the valuation report will be scrutinized, the valuer should double-check the variables used in its preparatory work and be able to justify them.
If you’re a trader or a long-term investor, share valuation is critical to your understanding and success. Thus, traders could indeed compare stocks of different companies using various methods of share valuation. Long-term investors can assess their growth opportunities using a variety of methods and strategies. As a result, it is critical to stay current on the best approaches of share valuation based on your objectives and aspirations.
References
- https://www.google.com/url?sa=t&source=web&rct=j&url=https://www.indiacode.nic.in/handle/123456789/2114%3Fview_type%3Dbrowse%26sam_handle%3D123456789/1362&ved=2ahUKEwjIkcOdsaLwAhWfumMGHY1VBJUQFjAeegQIMxAC&usg=AOvVaw3fxt1wY2zrf9fTSJjjjYdz
- https://corporatefinanceinstitute.com/resources/knowledge/finance/net-asset-value/
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