Back to Basics: Valuation of Ordinary Shares pt 1
Calculating the value of ordinary shares can be completed through four, clear methods for TPS students.
In this instance, we will look at valuing ordinary shares as part of a transaction – when we are either buying or selling shares.
When a company is unlisted, there is no published market price for the shares. The value of the ordinary shares will need to be calculated based on other available information using formulae, estimates and judgements. As a result, the values calculated can be subjective and, in practice, are subject to negotiation before a final price is agreed.
We are going to consider four different methods that can be used to calculate the value of ordinary shares. The choice of the most appropriate method will depend on the number of shares changing hands and the nature of the business.
Dividend yield method
Calculates the share price based on the ordinary dividend paid and an adjusted dividend yield.
Most appropriate when there is a minority shareholding (less than 40% of the ordinary share capital) changing hands.
Calculates the share price based on future maintainable earnings (FME) and an adjusted price earnings ratio.
Most appropriate when more than 50% of the ordinary share capital is changing hands.
Net asset method
Calculates the share price based on the net asset value on the statement of financial position.
Most appropriate when the value of the company is derived from the assets e.g. a property investment company. Also useful as a minimum benchmark.
Discounted cash flow method
Calculates the share price based on cash flows discounted at the purchaser’s cost of equity.
Most appropriate when cash flows are crucial to the success of a business and can be reliably estimated.
We can now look at the steps involved in calculating a valuation under each method.
1. Dividend yield method
The calculation is:
- Price of Share = Ordinary dividend per share / Adjusted dividend yield
Unlisted companies do not have published dividend yields. We therefore take the dividend yield of a listed company that is in the same industry and adjust it. Remember that a dividend yield is the yield (return) that shareholders receive in the form of a dividend.
We always adjust the dividend yield for the fact that an unlisted ordinary share is less marketable than a listed company share. We can also adjust the dividend yield for other factors e.g. risk, size and possible transferability restrictions in the Articles of Association. The net effect of the adjustments is that the adjusted dividend yield should be higher than the original dividend yield of the listed company.
2. Earnings method
The calculation is:
- Price of share = Earnings per share (based on FME) x Adjusted price earnings ratio
Unlisted companies do not have published price earnings (PE) ratios. So, just as in the dividend yield method, we need to adjust the PE ratio of a listed company in the same industry. Remember that a PE ratio is the number of times that the share price exceeds the earnings per share (EPS).
The adjustments we make are the same as the ones made to the dividend yield – they are just in the opposite direction – so the adjusted PE ratio will usually be lower than the original PE ratio of the listed company.
The earnings will also need to be reviewed to check whether these are maintainable i.e. do they represent the normal earnings of the business? Any unusual, one-off items should be adjusted for.
3. Net asset method
This is the easiest calculation as it is derived from the value of the net assets in the statement of financial position.
- Net assets = Total assets - Total liabilities = Total equity and reserves
- Price of share = Net assets / Number of ordinary shares in issue
4. Discounted cash flow method
This method requires an estimation of future cash flows. The cash flows used are those after debt finance payments, but before dividends are paid. The cash flows are usually estimated for a defined number of years and then a terminal multiplier is applied to the final estimated year; this represents cash flows that will be received into the future, which cannot be estimated with as much certainty.
All these cash flows are then discounted at a cost of equity. The cost of equity used is often that of the purchaser of the shares, calculated using the Capital Asset Pricing Model (CAPM) formula.
- CAPM = Risk free rate + Beta (Return on the market - risk-free rate)
- Price of a share = Total discounted cash flows / Number of ordinary shares in issue