Session 2: Share Capital Valuation

Share capital represents the capital provided by the owners of the business firm. This may be a combination of the start-up capital and the retained earnings which results from the accumulated profit. It is important to know how much the shareholders equity worth the on the capital structure of the firm.

Important learning Terms

• Dividends
• Earnings
• Earnings yield
• Price/Earning Ratio
• Dividend
• Dividend yield
• Dividend Cover

The Objective of Share Valuation
Share valuation may be required for any of the following reasons:

1. In the time of disposition of the share by the shareholders. The need to have a justifiable reliasation from the disposal of the shares.
2. When a private company wishes to go to public by obtaining a stock exchange quotation
3. When there some companies which have a proposal for merges or takeover involving private company
4. For taxation purposes –The objective is to have a basis for levying relevant taxes, i.e. capital gains, capital transfer tax, stamp duty, etc.

A share can be defined as the interest a shareholder in a company measured by the sum of money, for the purpose of liability in the first place and of interest.

The rights and obligations attached to a particular share depend upon the terms agreed at the time of issue or by any subsequent amendment.

Bases of Share Valuation
Share valuation can either be in income or on asset values. There are two incomes receivable on share, namely:-

1. Dividend income
2. Total income (earning attributable to each shareholder)

Dividend income is payable out of the attributable earnings and the two will only be equal when the company has a 100% dividend payout ratio. The following gives bases used for share valuation

• Earnings
• Dividends
• Assets

Abbreviations

Po = market price (present value) of the stock per share
Di = expected dividend i periods hence (i = 1, 2, 3, . . . n)
ks = the minimum required rate of return on the stock given its risk
Pn = the anticipated selling price of the stock at time n
g = expected growth rate of dividends

The Price/Earnings Model

Useful when a company's stock is not traded publicly and no market price exists

Method: 1) Determine the P/E ratio for the industry;
2) calculate the Earnings Per Share of the company;
3) multiply the (P/E)industry times the EPScompany

A. Common Stock Valuation (Total Common Equity)

Book Value Approach

BV per Share = (Total Assets - Total Liabilities)/# com stock shares

Example: Total Assets = $10 million; Total Liabilities = $4 million; number of common stock shares outstanding = 3 million

BV per share = ($10million - $4million)/3 million = $2.00 per share

Liquidation Value Model

Note: The liquidation model assumes assets are sold at below book value to reflect their poor or zero earning power.

From the previous example, using the asset value of $10million, assume the assets can be sold at a discount of $2million.

BV per shareliquidation = ($8 - $4)/3 million = $1.33 per share

Note: Liquidation value is a "worse case" scenario valuation assessment

B. Preferred Stock Valuation

Preferred stock is valued as a perpetuity. The preference shares differs from the ordinary shares in that they carry certain preferential rights. The common areas where the rights exist are:-
i) Dividend payment: Dividends are a fixed percent of par value –Dividend right
ii) Distribution in liquidation – Capital right

Diminishing importance of preference Shares.
The combined effect of inflation on fixed interest investments and the unfavorable tax treatment of preference shares compared t debentures has caused the virtual disappearance of the new issues of this type of shares.

Valuing Shares of Unquoted Company
Unquoted firms (those firms which have are not listed in the stock exchange market) can be done by the use of Free Cash flow discount model.

The Free Cash Flow DCF Model
The Free Cash Flow DCF Model takes consideration of discounting dividend cash flows, the free cash flow model discounts the total cash flows that would flow to the suppliers of the firm’s capital. Once the present value of those cash flows are determined, liabilities and preferred stock (if any) are subtracted to arrive at the present value of common stockholders’ equity.

Free cash flows to investors (debt and equity) are calculated as follows:

Free cash flow represents those amounts in each operating period that are “free” to be distributed to the suppliers of the firm’s capital, that is, the debt holders, the preferred stockholders, and the common stockholders

The output of the free cash flow model in this application is sometimes called the firm’s Enterprise Value.

QUESTIONS FOR DISCUSSION