CU-SEM-VI-Financial Analysis and Business Valuation

["Calculation of Normal Profit: Calculation of Super Profit: Super Profit = Actual or Average Profit \u2212 Normal Profit Super Profit = 50,000 \u2212 41,000 Super Profit = \u20b9 9,000 11.4 SUMMARY \uf0b7 There are several methods to calculate Goodwill. One such method of valuing Goodwill is a Capitalisation Profit Method. Under the Capitalisation Method, the capitalised value of the firm\u2019s profit is determined to know the amount of capital required to earn the desired profit. \uf0b7 Super profit is the excess of estimated future profit than the normal profit. It is a way of determining the extra profits that are earned by the business. The goodwill is determined by multiplying the value of super profits by a certain number (that number being the number of years of purchase). \uf0b7 The excess of the average profit over the typical profit is known as the super profit. The super profit is multiplied by the predetermined number of years after purchase to determine goodwill. The capital used in the firm produces a profit 201 CU IDOL SELF LEARNING MATERIAL (SLM)","11.5 KEYWORDS \uf0b7 Capitalisation Method Under the Capitalisation Method, the capitalised value of the firm\u2019s profit is determined to know the amount of capital required to earn the desired profit. \uf0b7 Super profit Super profit is the excess of estimated future profit than the normal profit. It is a way of determining the extra profits that are earned by the business. 11.6 LEARNING ACTIVITY 1. Explain super profit. ___________________________________________________________________________ ___________________________________________________________________________ 2. Explain Capitalistion Method. ________________________________________________________________________ ___ ___________________________________________________________________________ 11.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions: 1. Write the steps to calculate goodwill using super profit method. 2. Write the steps to calculate goodwill according to the Capitalisation of Average Profit Method. Long Questions: 1. Explain with example about super profit method. 2. Explain with example about capitalization method. B. Multiple Choice Questions 1. The process of estimating the economic value of a whole firm or company unit is known as a_______________ a. Business valuation 202 b. Business growth CU IDOL SELF LEARNING MATERIAL (SLM)","c. Business Development d. Business expansion 2. The_____________ mandates that a company's fair market value be used to determine its valuation. a. Internal Revenue Service (IRS) b. Internal Control Service c. Both a and b d. None of the above 3. ____________is the excess of estimated future profit than the normal profit. a) Super profit b) Income c) Revenue d) Surplus answers 1-a, 2-a, 3-a 11.8 REFERENCES References book \uf0b7 Financial Statement Analysis - Martin Fridson. ... \uf0b7 International Financial Statement Analysis - Thomas Robinson. ... \uf0b7 The Finance Book - Stuart Warner & Si Hussain. ... \uf0b7 Financial Statements: Step by Step - Thomas Ittelson Website \u25cf https:\/\/www.investopedia.com\/terms\/b\/business-valuation.asp \u25cf https:\/\/en.wikipedia.org\/wiki\/Business_valuation \u25cf https:\/\/www.uschamber.com\/co\/run\/finance\/business-valuation-how-to-guide 203 CU IDOL SELF LEARNING MATERIAL (SLM)","UNIT \u2013 12 PRESENT VALUE METHOD STRUCTURE 12.0 Learning Objectives 12.1 Introduction 12.2 Discounted Cash flow method 12.3 Calculation of FMP 12.4 Summary 12.5 Keywords 12.6 Learning Activity 12.7 Unit End Questions 12.8 References 12.0 LEARNING OBJECTIVES After studying this unit, you will be able to: \uf0b7 Describe FMP \uf0b7 Identify Calculation of FMP \uf0b7 Understand present value 12.1 INTRODUCTION Discounted cash flow (DCF) valuation may appear like a complex financial art form better left to Wall Street technical gurus and finance Ph.D.s. DCF complications require sophisticated financial modeling and mathematics. However, if you get the fundamental ideas underpinning DCF, you may run \\\"back-of-the- envelope\\\" calculations to assist in valuing small firms or making investment decisions. This article will go over a few real-world uses. Discounted cash flow (DCF) is a method of valuation used to determine the value of an investment based on its return or future cash flows.The weighted average cost of capital (WACC) is typically used as a hurdle rate, meaning the investment's return must outperform the hurdle rate. Although DCF is the standard for valuing privately-held companies; it can also be used as an acid test for publicly-traded stocks. 204 CU IDOL SELF LEARNING MATERIAL (SLM)","Discounted cash flow (DCF) valuation may appear like a complex financial art form better left to Wall Street technical gurus and finance Ph.D.s. DCF complications require sophisticated financial modeling and mathematics. However, if you get the fundamental ideas underpinning DCF, you may run \\\"back -of-the- envelope\\\" calculations to assist in valuing small firms or making investment decisions. This article will go over a few real-world uses. A method of valuation known as discounted cash flow (DCF) is used to estimate the value of an investment based on its expected return in the future, or future cash flows. DCF makes it easier to determine the current value of an investment based on expected future returns. DCF analysis can be used for both investments and asset purchases by business owners. DCF is a method of valuation that can be applied to privately held businesses. It forecasts a number of potential future cash flows or earnings before making time value of money adjustments. According to the idea of the time value of money, one dollar now is worth more than one dollar tomorrow because today's dollar can be invested. To decide if future cash flows from an investment or a project are worthwhile, discounted cash flow analyses uses a discount rate. The return that could be received without taking any risks, or the discount rate, is what is calculated. A discount rate, for instance, could be the cost of a two-year U.S. Treasury note It is not worthwhile to pursue a project or venture if it cannot produce sufficient cash flows to outperform the Treasury rate (or risk-free rate). To decide if an investment is worth the risk, the risk-free rate is, in other words, removed (or discounted) from the projected returns of the investment to arrive at the true investment gain. 12.2 DISCOUNTED CASH FLOW METHOD The discounted cash flow (DCF) analysis approach lowers the projected future cash flows to determine the investment value. DCF analysis is frequently employed in both the investing business and corporate finance management since it can be used to value a stock, company, project, among many other assets or activities. After accounting for the time value of money, DCF analysis calculates the value of return that an investment produces. It can be used for any investments or initiatives that are anticipated to provide future cash flows. 205 CU IDOL SELF LEARNING MATERIAL (SLM)","The DCF and the initial investment are frequently contrasted. The investment is profitable if the DCF exceeds the current cost. The investment yields a bigger return the higher the DCF. Investors should prefer holding the cash if the DCF is less than the current cost. Estimating future cash flows over a certain time period and the investment's terminal value are the first steps in a DCF analysis. Your investment horizon could be the estimation term. If extra investment is needed during that time, a future cash flow could be negative. The next step is to choose the right rate to discount the future cash flows to the present. The discount rate is often the cost of capital, which varies greatly depending on the project or investment. The weighted-average cost of capital (WACC) method may be used if a project is funded by both loan and equity. The Calculation of Discounted Cash Flow The steps to be taken to calculate present value under the discounted cash flow method are as follows: 1. Itemize all positive and negative cash flows associated with an investment. This can include the following: \uf0b7 The initial purchase \uf0b7 Subsequent maintenance on the initial purchase \uf0b7 The working capital investment associated with the initial purchase \uf0b7 The profit on sales of the goods and services derived from the investmen \uf0b7 The amount of income tax sheltered by the depreciation on the acquired asset \uf0b7 The working capital reduction that occurs once the asset is later sold \uf0b7 The salvage value of the asset that is expected when it is sold at the end of its useful life 2. Determine the cost of capital of the investor. This is the after-tax cost of the investor's debt, preferred stock, and common stock. It may also be adjusted upward to account for the additional risk associated with an investment. The cost of the investor's common stock is the most expensive and difficult to calculate. 206 CU IDOL SELF LEARNING MATERIAL (SLM)","3. Plug the cash flows from Step 1 and the cost of capital from Step 2 into the following calculation to derive the present value of all cash flows: Net present value = X \u00d7 [(1+r)^n - 1]\/[r \u00d7 (1+r)^n] Where: X = The amount received per period n = The number of periods r = The required return (cost of capital) 12.3 CALCULATION OF FUTURE MAINTAINABLE PRICE Determining future maintainable profits based on historical performance is a delicate and challenging task because it involves not only the objective analysis of the financial data that is currently available but also the subjective assessment of a wide range of other factors, including the management skills of the company, broader economic conditions, potential government policies, etc. Only the former is subject to guiding principles, and the valuer must take into account the other factors in each case individually based on how he interprets the circumstances. The processes required to determine a company's future maintainable profits are: (a) calculating the company's historical average taxed earnings; (b) estimating the company's future maintainable taxed profits; and (c) adjusting preferred rights. (a) How to compute historical average earnings: To calculate historical average earnings, choose the years whose results should be used for averaging; next, choose these years and modify their profits to make them suitable for averaging. An average for a shorter period might not be appropriate; the number of years to be chosen must be sufficient to generally cover the length of a business cycle. However, it shouldn't go too far back; for instance, the outcomes from the 1980s won't have any impact on the outcomes anticipated for the 1990s. A somewhat shorter time is thought to be more representative in today's inflationary settings because it shows more current results. 207 CU IDOL SELF LEARNING MATERIAL (SLM)","Similar to this, the average over a shorter time period is more helpful for businesses that are growing steadily and gradually. In some unusual situations, the average over an even shorter period of time or even just one year's profit may be more important in estimating future earnings, such as when a change in the business or a change in trading conditions forces the valuer to ignore earlier years and rely solely on one year or to choose some typical years and disregard others. The valuer would only benefit from sound reasoning in all of these situations. The specifics of each instance determine whether a 3-year, 5-year, or longer average would accurately predict a company's future revenues. The followings are some items which generally require adjustment in arriving at the average of the past earnings: (i) Elimination of material non recurring items such as loss of exceptional nature through strikes, fires, floods and theft, etc., profit or loss of any isolated transaction not being part of the business of the company, lumpsum compensation or retiring allowances, damages and costs in legal actions, abnormal repair charges in a particular year, etc. (ii) Elimination of income and profits and losses from non-trading assets. (iii) Elimination of any capital profit or loss or receipt or expense included in the profit and loss account. (iv) Adjustments for any interest, remuneration, commission, etc., foregone or overcharged by directors and other managerial personnel. (v) Adjustments for any matters suggested by notes, appended to the accounts or by qualifications in the Auditor\u2019s Report, such as provision for taxation and gratuities, bad debts, under or over provision for depreciation, inconsistency in valuation of stock, etc. (vi) Taxation: According to the opinion of the valuer, the tax rates may be such as were ruling for the respective years or the latest ruling rate may be deducted from the average profit. However, the consensus of opinion is for adjusting tax payable rather than tax-paid because so many short-term reliefs and tax holidays might have reduced the effective tax burden. (vii) Depreciation: It is a significant item that calls for careful review. The valuer may adopt book depreciation provided he is satisfied that the rate was realistic and the method was suitable for the nature of the company and they were consistently applied from year to year. But imbalances do arise in cases where consistently written down value method was in use 208 CU IDOL SELF LEARNING MATERIAL (SLM)","and heavy expenditure in the recent past has been made in rehabilitating or expanding fixed assets, since the depreciation charges would be unfairly heavy and would prejudice the seller. Under such circumstances, it would be desirable to readjust depreciation suitably as to bring a more equitable charge on the profits meant for averaging. The trend of profits earned is a factor to be taken into account while averaging previous earnings. The record of past earnings must be the sole basis for any estimation of maintainable profits; nevertheless, if prior results are used carelessly, the result could be completely false and unrealistic. Three scenarios could need to be dealt with in this regard. An average cannot help with future projections when a company's historical profits have experienced significant year-to-year variation. In these situations, it may be required to look into the company's entire history as well as its earnings over a considerable amount of time. When a company's profits don't follow a predictable rising or falling trend, it can be helpful to anticipate future earnings using the cycle's average. In some businesses, profits may show a clear rising or dropping tendency from year to year. In these cases, a simple average overlooks a crucial component, namely the trend in earning potential. The value of a company's shares would unquestionably be higher if its historical profit trend showed a clear upward tendency as opposed to one that shows a static or downward trend. In these situations, a weighting average that favors the most recent years over the earlier ones is suitable. A straightforward method of weighting is to multiply the earnings by the corresponding number of the years, organized chronologically, with the most recent year receiving the greatest weight and the furthest away the least. (Likewise, if net worth is being taken into account, the corresponding years' average net worth may likewise be weighted similarly. (b) Projection of future maintainable taxed profits: Projection is more a matter of intelligent guesswork since it is essentially an estimation of what will happen in the risky and uncertain future. The average profit earned by a company in the past could be normally taken as the average profit that would be maintainable by it in the future, if the future is considered basically as a continuation of the past. If future performance as the company is viewed as departing significantly from the past, then appropriate adjustments will be called for before accepting the past average profit as the future maintainable profit of the company. These are stated below: 209 CU IDOL SELF LEARNING MATERIAL (SLM)","i) Discontinuance of a part of the business; (ii) Under-utilisation of installed capacity; (iii) Expansion programmes; (iv) Major change in the policy of the company; and (v) Adjustment for rehabilitation and replacement. (c) Adjustments of preferred rights: In arriving at the average profits and their future projection, all charges including interest on debentures and other borrowings are of course deducted. But the dividend on preference shares should also be considered after the estimate of future profits has been arrived at. Dividends payable to preference shareholders, according to the terms of their issue, should be deducted from the maintainable profit. Example: Example 210 CU IDOL SELF LEARNING MATERIAL (SLM)","12.4 SUMMARY \uf0b7 Discounted cash flow (DCF) valuation may appear like a complex financial art form better left to Wall Street technical gurus and finance Ph.D.s. DCF complications require sophisticated financial modeling and mathematics. \uf0b7 The discounted cash flow (DCF) analysis approach lowers the projected future cash flows to determine the investment value. DCF analysis is frequently employed in both the investing business and corporate finance management since it can be used to value a stock, company, project, among many other assets or activities. \uf0b7 After accounting for the time value of money, DCF analysis calculates the value of return that an investment produces. It can be used for any investments or initiatives that are anticipated to provide future cash flows. \uf0b7 Determining future maintainable profits based on historical performance is a delicate and challenging task because it involves not only the objective analysis of the financial data that is currently available but also the subjective assessment of a wide range of other factors, including the management skills of the company, broader economic conditions, potential government policies, etc. Only the former is subject to guiding principles, and the valuer must take into account the other factors in each case individually based on how he interprets the circumstances. The processes required to determine a company's future maintainable profits are: (a) calculating the company's historical average taxed earnings; (b) estimating the company's future maintainable taxed profits; and (c) adjusting preferred rights. 211 CU IDOL SELF LEARNING MATERIAL (SLM)","12.5 KEYWORDS \uf0b7 Discounted cash flow (DCF) It refers to a valuation method that estimates the value of an investment using its expected future cash flows. \uf0b7 Future Maintainable Profit (F.M.P)Valuer has to take in to consideration the Average Adjusted Past Profit & various economic factor which has got crucial impact on the concern. It is nothing but continuation of Past Profit in future . 12.6 LEARNING ACTIVITY 1. Explain DCF ___________________________________________________________________________ ___________________________________________________________________________ 2. Explain FMP ___________________________________________________________________________ ___________________________________________________________________________ 4. What is format for FMP? ___________________________________________________________________________ ___________________________________________________________________________ 12.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions: 1. Write the steps to calculate fmp. 2. Write the steps to calculate DCF. Long Questions: 1. Explain with example about present value method 2. Explain with example about DCF B. Multiple Choice Questions 212 CU IDOL SELF LEARNING MATERIAL (SLM)","1. According to the opinion of the valuer, the tax rates may be such as were ruling for the respective years or the latest ruling rate may be deducted from the ________ a. average profit b. normal growth c. usiness profit d. Business expansion 2. _______ is a method of valuation used to determine the value of an investment based on its return or future cash flow a. DCF b. Normal profit c. FMP d. None of the above 3. ____________is the excess of estimated future profit than the normal profit. a. Super profit b. Income c. Revenue d. Surplus answers 1-a, 2-a, 3-a 12.8 REFERENCES References book \uf0b7 Financial Statement Analysis - Martin Fridson. ... \uf0b7 International Financial Statement Analysis - Thomas Robinson. ... \uf0b7 The Finance Book - Stuart Warner & Si Hussain. ... \uf0b7 Financial Statements: Step by Step - Thomas Ittelson. Website \u25cf https:\/\/www.investopedia.com\/ask\/answers\/032615\/what-formula-calculating-net- present-value- 213 CU IDOL SELF LEARNING MATERIAL (SLM)","npv.asp#:~:text=Net%20present%20value%20(NPV)%20is,to%20turn%20the%20gre atest%20profit. 214 CU IDOL SELF LEARNING MATERIAL (SLM)","UNIT - 13VALUATION OF SHARES I STRUCTURE 13.0Learning Objectives 13.1Introduction 13.2Methods of valuation of shares 13.2.1 Net Assets method 13.2.2 Yield method 13.3Normal Rate of Return 13.4Summary 13.5Keywords 13.6Learning Activity 13.7Unit End Questions 13.8 References 13.0 LEARNING OBJECTIVES After studying this unit, you will be able to: \uf0b7 Describe Net assets method \uf0b7 Understand the yield method \uf0b7 State the Meaning rate of return 13.1 INTRODUCTION The process of determining the worth of a company's shares is called share valuation. Share valuation is done using mathematical methods, and share value varies according to market supply and demand. It is simple to find out the share price of publicly traded listed corporations. However, valuing shares for private corporations whose stock is not traded publicly is crucial and difficult. The intrinsic value of a stock can be ascertained through stock valuation. The theoretical or intrinsic value of the stock is independent of its actual market price. As a result, stock valuation is much more significant. 215 CU IDOL SELF LEARNING MATERIAL (SLM)","An investor can determine if a stock is overvalued or undervalued from its present market price once they are aware of the intrinsic worth of the stock. Additionally, it aids in estimating the stock's potential movement and future price. Using certain set formulas and methods, an investor can find out the value of the stock or share. All the methods work on some set parameters that help you determine the value of the stock. Some of the parameters are fundamentals of the company, reports on the stock performance, sectoral trends, etc. If the shares are traded on a stock exchange, a ready method for determining the value assigned to them by buyers and sellers is available, so the valuation issue is avoided. Even occasionally, the stock market quotations do not reflect the genuine worth of the shares, thus an experienced valuer must determine the value of the shares by using a good and logical foundation. The rules for the valuation of shares are provided by the various tax laws, and the precise steps to be taken have also been specified. The process of determining the worth of a company's shares is called share valuation. Quantitative methods are used to value shares. Share values will change based on market supply and demand. It is simple to find out the share price of publicly traded listed corporations. However, because private company shares are not traded on the open market, their valuation is extremely significant and difficult. 13.2 METHODS OF VALUATION OF SHARES The different methods of valuation of shares are classified as under: A. Net Assets (Intrinsic Value or Breakup Value) Method. B. Dividend Yield Method. C. Earning Capacity Method. D. Fair Value Method 13.2.1 Net Assets method (A) Net Assets Method 216 CU IDOL SELF LEARNING MATERIAL (SLM)","This strategy, which focuses on the assets backing per share, can either assume that the company is still operating or assume that it is being liquidated. This approach is also known as the breakdown value approach, the asset backing approach, and the asset valuation approach. The net tangible assets must be estimated in order to value the share using this method. The assets are taken at market value and comprise both trading and non-trading assets. First Method Calculation of Net Assets Assets at Market Value, if any Second Method Net Assets = Equity Share Capital + Reserves and Surplus + Accumulated Profits + Profit on Revaluation of Assets \u2013 Accumulated Losses \u2013 Preliminary Expenses Value of Share = Value of Net Assets\/Number of Equity Shares Illustration The following is the summarized Balance Sheet of X Ltd 217 CU IDOL SELF LEARNING MATERIAL (SLM)","Table 13.1eqity Liabilities Goodwill is revalued at Rs. 2, 50,000, while Plant and Machinery is expected to realize Rs. 2, 85,000. Debtors are subjected to the Provision for bad debts @7%. Calculate the value of share on the Net Assets basis. Solution Step 1: Calculation of Net Assets Net Assets = Realizable Value of Assets \u2013 Outside Liabilities Goodwill = 2, 50,000 Plant and Machinery = 2, 85,000 Furniture = 50,000 Investments = 4, 40,000 Stock = 1, 80,000 218 CU IDOL SELF LEARNING MATERIAL (SLM)","Debtors (1, 20,000 \u2013 7% of 1, 20,000) = 1, 11,600 Bank Balance = 50,000 Less: 12% Debentures = (4, 00,000) Less: Creditors = (44,000) Less: Provision for Taxation = (50,000) Less: Employees Provident Fund = (1, 05,000) Net Assets = 7, 67, 600 Illustration The following is the summarized Balance Sheet of X Ltd. 219 CU IDOL SELF LEARNING MATERIAL (SLM)","Table 13.2 Illustration The Fixed Assets are valued at Rs. 16, 20,000 for the purpose of valuation of shares; Goodwill shall be taken at two times the Average Annual Profits of the last three years\u2019 which were Rs. 3, 00,000, Rs. 6, 00,000 and Rs. 7, 00,000. Interest on debentures is outstanding for six months. There is a liability of Rs. 24,000 not recorded in the books. Find out the value per share on the basis of Net Assets Method. Solution Step 2: Calculation of Net Assets Net Assets = Realizable Value of Assets \u2013 Outside Liabilities Step 3: Distribution of Net Assets between Different Equity Shareholders 220 Ratio of Equity Shares: 6,00,000 : 4,00,000 ; 2,00,000 : 1,00,000 CU IDOL SELF LEARNING MATERIAL (SLM)","6: 4: 2: 1 Step 4: Calculation of Value of Shares Value of Share = Net Assets\/No. of Equity Shares 13.2.2 Yield Method (B) Dividend Yield Method The net assets method's primary drawback, as previously mentioned, is that it may only be applied during liquidation. However, the value of the shares in terms of investment returns is something that shareholders are constantly curious about. He evaluates his returns in relation to the cost he paid for the share. As a result, using this method, the predicted dividend rate is compared to the average dividend rate currently in use in the industry to determine the share's value. Under this approach, shares are valued using the formula below: 221 CU IDOL SELF LEARNING MATERIAL (SLM)","Calculation of Expected Rate of Dividend: For the calculation of the expected rate of dividend the profit available for Equity shareholders is calculated as follows: Profit of the company \u2026\u2026\u2026\u2026\u2026 Less: Income Tax \u2026\u2026\u2026\u2026\u2026 Less: Transfer to Reserve \u2026\u2026\u2026\u2026\u2026 Less: Transfer to Debenture Sinking Fund \u2026\u2026\u2026\u2026\u2026 Less: Preference Dividend \u2026\u2026\u2026\u2026\u2026 Amount for Equity Shareholders \u2026\u2026\u2026\u2026\u2026 This amount available for equity shareholders is divided by the paid-up equity capital for the calculation of Expected Rate of Dividend. Thus: Calculation of Normal Rate of Dividend: Normal Rate of Dividend is normally given in the question. This rate is different in different industry. Higher the risk in the business, higher will be the normal rate of dividend Illustration: From the following information relating to a company calculate the value of its equity share with Dividend Yield Method. Issued Equity Share Capital 20,000 shares of Rs. 10 each Paid-up Equity Capital Rs. 8 per share 6% Preference Share Capital 2,00,000 shares of Rs. 10 each fully paid up Annual transfer to General Reserve 20% 222 CU IDOL SELF LEARNING MATERIAL (SLM)","Rate of Tax 50% Expected Profits before Tax Rs. 4,00,000 Normal Rate of Dividend 15% Solution Step 1: Calculation of Profit available for Equity Shareholders Step 2: Calculation of Expected Rate of Dividend =40000\/160000 x100 = 25% Step 3: Calculation of Value of Equity Share Value of Equity Share = Expected Rate\/ Normal Rate \u00d7 Paid-up value per share = 25\/15x 8 =13.33 Illustration The paid-up share capital of the company consists of 4,000, 5% preference shares of Rs. 100 each and 8,000, equity shares of Rs. 100 each. In addition to the fixed dividend of 5%, the 223 CU IDOL SELF LEARNING MATERIAL (SLM)","preference shareholders are also entitles to participate in the profits up to 4% after payment of dividend of 10% on the equity shares. Any surplus of profits was available for the company shareholders. The annual average profits of the company are Rs. 2, 00,000 after providing for depreciation and taxes and it is considered necessary to transfer Rs. 12,000 per annum to reserve fund. The normal return expected on preference shares is 10% and that on equity shares is 12%. Calculate the value of each Preference Share and Equity Share in the company. Solution Step 3: Calculation of Value of Share 224 Value of Preference Share = expected Rate \/Normal Rate \u00d7 Paid-up value per share Value of Preference Share =9\/10 \u00d7 100 = Rs. 90 CU IDOL SELF LEARNING MATERIAL (SLM)","Value of Equity Share = expected Rate \/Normal Rate \u00d7 Paid-up value per share Value of Preference Share =19\/12 \u00d7 100 = Rs. 158.33 13.3 NORMAL RATE OF RETURN The rate of losses or gains from an investment is referred to as the typical rate of return. In other words, it is the process of calculating an investment's earnings after deducting capital, investment, and operational costs. Investors use it as a benchmark to determine if a company is a good investment or if they should go elsewhere. Businesses utilize it to determine how much profit is being made on a fair basis and by what proportion. Those looking to launch a new business may use this evaluation. The data can be found by examining the posted profits of a spectrum for a comparable industry-related business, taking into account elements such the environment and other concerns that can influence that specific business at its intended location. For instance, a potential watch manufacturing business owner would research the industry's rate of losses or profits in relation to things like taxes, import levies, and other potential influences on firm profitability. Even if sales and pricing of the products are equal across markets, these factors typically have an impact on a company's profit. Even if two businesses produce the same good and sell the same amount of it each month at the same price, their usual rates of return may differ. This can be a result of where the firms are located. One of the companies can be situated in a region where the government offers certain tax breaks and lowers customs fees for particular essential raw supplies. If the business can get inexpensive labor, that may also have an impact on the rate. With lower operating costs than another comparable company operating in a less favorable environment, profits will be higher. The usual rate of return is influenced and determined by the unique markets in different industries. An industry that makes clothing, for instance, will have a different rate than one that makes cars. The industry-specific risk factor is one of the elements that influences how a market could be characterized as profitable. Contrary to lower-risk markets, which may be considered successful with only a fraction of the same profit, industries with higher risk elements typically require a significant margin of return before they can be considered lucrative. 225 CU IDOL SELF LEARNING MATERIAL (SLM)","Normal Rate of Return: Since the normal level of profit is determined from the aforementioned anticipation of the stated investors, the rate of earning which is anticipated by the investors from their investments has a significant impact on the valuation of goodwill. The normal rate of return is defined as the return that satisfies a general investor on his investment in a firm or industry. There are several other names for it, including Average Rate of Return, Normal Rate of Earnings, Yield, Reasonable Rate of Return, Rate of General Expectations, Standard Rate of Return, etc. The normal rate of return should be adjusted after adjusting certain conditions: (i) Higher Bank Rate If the bank rate increases, investors also expect a higher rate of return, (ii) Periods of Investments: If the period of investment is short, the rate of return will be lower, and vice versa. (iii) Risk: Risky investment always requires a higher rate of return. (iv) General boom: If there is a boom in the industry, the investors expect a higher rate of return and, as such, normal rate of return increases. 13.4 SUMMARY \uf0b7 Net Asset Method:This strategy, which focuses on the assets backing per share, can either assume that the company is still operating or assume that it is being liquidated. This approach is also known as the breakdown value approach, the asset backing approach, and the asset valuation approach. The net tangible assets must be estimated in order to value the share using this method. The assets are taken at market value and comprise both trading and non-trading assets. \uf0b7 The process of determining the worth of a company's shares is called share valuation. Quantitative methods are used to value shares. Share values will change based on market supply and demand. It is simple to find out the share price of publicly traded 226 CU IDOL SELF LEARNING MATERIAL (SLM)","listed corporations. However, because private company shares are not traded on the open market, their valuation is extremely significant and difficult. \uf0b7 The usual rate of return is influenced and determined by the unique markets in different industries. An industry that makes clothing, for instance, will have a different rate than one that makes cars. The industry-specific risk factor is one of the elements that influences how a market could be characterized as profitable. Contrary to lower-risk markets, which may be considered successful with only a fraction of the same profit, industries with higher risk elements typically require a significant margin of return before they can be considered lucrative. 13.5 KEYWORDS \uf0b7 Net Assets Method This strategy, which focuses on the assets backing per share, can either assume that the company is still operating or assume that it is being liquidated. This approach is also known as the breakdown value approach, the asset backing approach, and the asset valuation approach. The net tangible assets must be estimated in order to value the share using this method. The assets are taken at market value and comprise both trading and non-trading assets.Debt to asset ratio \uf0b7 Debt to Equity ratio The debt to equity ratio and the debt to assets ratio both assess a company's funding structure. This ratio indicates how much of the company's funding comes from stock in this scenario. \uf0b7 Capital Employed It is also called as Net Tangible Assets (NTA) .While calculating the Capital Employed only trading assets & investments to be taken into consideration .Capital employed is to be considered only on certain date so it is better to calculate Average Capital Employed during the year. \uf0b7 Profits Method (i) The Number of Years Purchase Method: Under this method, the goodwill is valued at the agreed number of years\u2019 of purchase of the super profits of the firm. 13.6 LEARNING ACTIVITY 1. Define Net asset method ___________________________________________________________________________ ___________________________________________________________________________ 2. State the various methods of valuation. 227 CU IDOL SELF LEARNING MATERIAL (SLM)","________________________________________________________________ ___________ ___________________________________________________________________________ 3. What is NRR? ___________________________________________________________________________ ___________________________________________________________________________ 13.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions: 1. Define NRR? 2. Explain what is yield method? 3. Describe briefly valuation of Shares? Long Questions: 1. What is a Methods of valuation of shares? 2. What is NRR? 3. Explain in detail about valuation of shares? B. Multiple Choice Questions 1. The intrinsic value of a stock can be ascertained through ________ a. stock valuation b. Net asset method c. NRR d. None of the above 2. the predicted _____ is compared to the average dividend rate currently in use in the industry a. dividend rate b. Net asset c. NRR d. Above all 228 CU IDOL SELF LEARNING MATERIAL (SLM)","3. The process of determining the worth of a company's shares is called ___________ a. share valuation b. Net asset c. NRR d. Yield method Answers 1-a, 2-a, 3-a 13.8 REFERENCES References book \uf0b7 Financial Statement Analysis - Martin Fridson. ... \uf0b7 International Financial Statement Analysis - Thomas Robinson. ... \uf0b7 The Finance Book - Stuart Warner & Si Hussain. ... \uf0b7 Financial Statements: Step by Step - Thomas Ittelson. Website \u25cf https:\/\/cleartax.in\/s\/valuation-of- shares#:~:text=Valuation%20of%20shares%20is%20the%20process%20of%20 knowing%20the%20value,publicly%20can%20be%20known%20easily. \u25cf https:\/\/www.elearnmarkets.com\/blog\/share-valuation\/ \u25cf https:\/\/blog.ipleaders.in\/valuation-of-shares\/ 229 CU IDOL SELF LEARNING MATERIAL (SLM)","UNIT \u2013 14 VALUATION OF SHARES II STRUCTURE 14.0Learning Objectives 14.1Introduction 14.2Methods of Valuation of shares 14.2.1 Capitalisation factor 14.2.2 FMP 14.3Summary 14.4Keywords 14.5Learning Activity 14.6Unit End Questions 14.7References 14.0 LEARNING OBJECTIVES After studying this unit, you will be able to: \uf0b7 Describe FMP \uf0b7 Identify scope of Capitalisation factor \uf0b7 State the need and importance of capitalisation factor 14.1 INTRODUCTION The process of determining the worth of a company's shares is called share valuation. Share valuation is done using mathematical methods, and share value varies according to market supply and demand. It is simple to find out the share price of publicly traded listed corporations. However, valuing shares for private corporations whose stock is not traded publicly is crucial and difficult. The intrinsic value of a stock can be ascertained through stock valuation. The theoretical or intrinsic value of the stock is independent of its actual market price. As a result, stock valuation is much more significant. 230 CU IDOL SELF LEARNING MATERIAL (SLM)","An investor can determine if a stock is overvalued or undervalued from its present market price once they are aware of the intrinsic worth of the stock. Additionally, it aids in estimating the stock's potential movement and future price. Using certain set formulas and methods, an investor can find out the value of the stock or share. All the methods work on some set parameters that help you determine the value of the stock. Some of the parameters are fundamentals of the company, reports on the stock performance, sectoral trends, etc. If the shares are traded on a stock exchange, a ready method for determining the value assigned to them by buyers and sellers is available, so the valuation issue is avoided. Even occasionally, the stock market quotations do not reflect the genuine worth of the shares, thus an experienced valuer must determine the value of the shares by using a good and logical foundation. The rules for the valuation of shares are provided by the various tax laws, and the precise steps to be taken have also been specified. The process of determining the worth of a company's shares is called share valuation. Quantitative methods are used to value shares. Share values will change based on market supply and demand. It is simple to find out the share price of publicly traded listed corporations. However, because private company shares are not traded on the open market, their valuation is extremely significant and difficult. 14.2 METHODS OF VALUATION OF SHARES The different methods of valuation of shares are classified as under: A. Net Assets (Intrinsic Value or Breakup Value) Method. B. Dividend Yield Method. C. Earning Capacity Method. D. Fair Value Method 231 CU IDOL SELF LEARNING MATERIAL (SLM)","14.2.1 Capitalisation Factor A capitalization rate (or \\\"cap rate\\\") is a rate of return (represented as a percentage) obtained by subtracting a growth factor from the subject company's weighted average cost of capital (WACC). The cap rate is a combined rate of return on a company's total capital, which includes its debt and equity components. To translate a point estimate of cash flow into value, apply the cap rate. The term \\\"multiple\\\" refers to a capitalization rate's inverse. Capitalization rates take into consideration three variables: \uf0b7 the returns on equity, which is a function of the business' operating risk, excluding consideration of its financial risk; \uf0b7 the appropriate long-term capital structure of debt vs. equity; and \uf0b7 the marginal income tax rate at which interest expense is deducted. Capitalization rates are applied to maintain discretionary cash flows before interest expenses. The capitalization rate is used most often to determine the terminal value in a discounted cash flow valuation analysis. A lower multiple and valuation are indicative of increased risk, which is represented by a higher capitalization rate. When compared to a cap rate of 25% or a multiplier of 4.0x, a capitalization rate of 20% is equivalent to a multiple of 5.0x. Capitalisation method is one of the methods that is used for goodwill valuation. In this method, the value of goodwill is calculated by deducting actual capital employed from the capitalisation value of average profits based on the normal rate of return. There are two ways of calculating profits in capitalisation method and these methods are 1. Capitalisation of Average Profit Method 2. Capitalisation of Super Profits Method Capitalization of Average Profit Method: Using the capitalization of average profit method, the goodwill value is calculated by deducting the actual capital used from the average profits' capitalized value, which is calculated using the standard rate of return. Goodwill = Normal Capital \u2013 Actual Capital Employed or 232 CU IDOL SELF LEARNING MATERIAL (SLM)","Goodwill = Capitalised Average Profits \u2013 Actual Capital Employed where, Capitalised Average Profits or Normal Capital = Average estimated profits x 100 \/ Normal Rate of Return Actual capital employed or Net Asset of Business = Total Assets ( excluding goodwill, non- traded investments and fictitious assets ) \u2013 Outsiders liabilities Steps in calculating goodwill by capitalisation of average profit method Step 1: Calculate average estimated profits Step 2: Calculate the capitalised average profit Step 3: Calculate the value of Actual capital employed or net assets of the business Step 4: Calculate goodwill by subtracting the actual capital employed from the capitalised average profit Capitalisation of Super Profits Method: In this method, the goodwill valuation is determined by capitalising the super profit on the basis of normal rate of return. The formula for the Capitalisation of Super Profits Method is Capitalisation of Super Profits Method = Average of Annual Super Profits x 100 \/ Normal rate of return Illustration: The following illustration will help in understanding the concept of capitalisation of average profit method more clearly. Bhatt and Sons are able to earn a profit of 90,000 by infusing a capital of 5,00,00. The normal rate of return is 15%. Determine the value of goodwill by using capitalisation of super profit method. Solution Normal profit = Capital employed x Normal rate of return \/ 100 = 5,00,000 x 15 \/ 100 233 CU IDOL SELF LEARNING MATERIAL (SLM)","= 75000 Super profit = Average profit \u2013 Normal Profit = 90000 \u2013 75000 = 15000 Goodwill = Average of annual super profit x 100 \/ Normal Rate of return = 15000 x 100 \/ 15 = 100000 14.2.2 FMP It is nothing more than the likelihood of future earnings being made. This predicted future profit must be determined based on past gains, which is crucial when determining the goodwill value. The following points should carefully be considered at the time of estimating future profit: (i) Normal working expenses should be accounted for including depreciation on assets, interest on debentures etc.; (ii) Appreciation in fixed assets should not be included whereas appreciation in current assets should, however, be included; (iii) Income from non-trading assets should be excluded; (iv) Non-recurring expenses which may not be incurred in future are not to be included; (v) Any casual income (which is not expected in future) should not be included; (vi) Provision should be made for taxation; (vii) If any reserve is created, the same should be deducted; and (viii) Preference dividend should always be deducted from profit. Illustration 1: The following information is presented for five years ending 31st Dec. 2008: 234 CU IDOL SELF LEARNING MATERIAL (SLM)","Table 14.1 Illustration Fixed assets have been revalued and the same showed an appreciation of Rs. 5, 00,000 (depreciation to be provided for @ 10% p.a.). The company has a 8% preference share capital of Rs. 1, 00,000. The current rate of taxation may be taken @ 50%. Calculate the future maintainable profit. Solution: Average Profit (before tax and Directors\u2019 remuneration) (i.e. Profit + Tax + Directors\u2019 Remuneration) Table 14.2 Illustration Directors\u2019 remuneration has been considered as Rs. 6,000, i.e. the amount prevailing on 31st Dec. 2008, and not the average, since the same cannot be paid less than Rs. 6,000 in future. 235 CU IDOL SELF LEARNING MATERIAL (SLM)","14.3 SUMMARY \uf0b7 The intrinsic value of a stock can be ascertained through stock valuation. The theoretical or intrinsic value of the stock is independent of its actual market price. As a result, stock valuation is much more significant. \uf0b7 An investor can determine if a stock is overvalued or undervalued from its present market price once they are aware of the intrinsic worth of the stock. Additionally, it aids in estimating the stock's potential movement and future price. \uf0b7 Using certain set formulas and methods, an investor can find out the value of the stock or share. All the methods work on some set parameters that help you determine the value of the stock. Some of the parameters are fundamentals of the company, reports on the stock performance, sectoral trends, etc. \uf0b7 A capitalization rate (or \\\"cap rate\\\") is a rate of return (represented as a percentage) obtained by subtracting a growth factor from the subject company's weighted average cost of capital (WACC). The cap rate is a combined rate of return on a company's total capital, which includes its debt and equity components. \uf0b7 To translate a point estimate of cash flow into value, apply the cap rate. The term \\\"multiple\\\" refers to a capitalization rate's inverse. \uf0b7 Capitalization rates take into consideration three variables: \uf0b7 the returns on equity, which is a function of the business' operating risk, excluding consideration of its financial risk; \uf0b7 the appropriate long-term capital structure of debt vs. equity; and \uf0b7 the marginal income tax rate at which interest expense is deducted. \uf0b7 Capitalization rates are applied to maintain discretionary cash flows before interest expenses. The capitalization rate is used most often to determine the terminal value in a discounted cash flow valuation analysis. 14.4 KEYWORDS \uf0b7 FMP It is nothing more than the likelihood of future earnings being made. This predicted future profit must be determined based on past gains, which is crucial when determining the goodwill value. \uf0b7 A capitalization rate It is (or \\\"cap rate\\\") is a rate of return (represented as a percentage) obtained by subtracting a growth factor from the subject company's weighted average cost of capital (WACC). The cap rate is a combined rate of return on a 236 CU IDOL SELF LEARNING MATERIAL (SLM)","company's total capital, which includes its debt and equity components.Debt to asset ratio 14.5 LEARNING ACTIVITY 1. Define FMP ___________________________________________________________________________ ___________________________________________________________________________ 2. State the Meaning of Capitalisation factor ______________________________________________________________ _____________ ___________________________________________________________________________ 3. Explain the method of valuation of shares ___________________________________________________________________________ ___________________________________________________________________________ 14.6 UNIT END QUESTIONS A. Descriptive Questions Short Questions: 1. Define valuation of shares? 2. Explain what is FMP? 3. Describe briefly about Capitalisation factor? Long Questions: 1. What is a valuation of shares? Explain the various types ? 2. Describe the FMP in detail B. Multiple Choice Questions 1. The process of determining the worth of a company's shares is called _____________ a. share valuation b. FMP 237 CU IDOL SELF LEARNING MATERIAL (SLM)","c. capitalization d. none of the above 2. The _________ is a combined rate of return on a company's total capital, which includes its debt and equity components. a. cap rate b. Real rate c. fmp rate d. share rate 3. _______ are applied to maintain discretionary cash flows before interest expenses a. Capitalization rate b. Valuation rate c. Fmp rate d. None of the above 4. the goodwill valuation is determined by capitalising the super profit on the basis of ________ a. normal rate of return b. FMP c. Goodwill d. Shares value Answers 1-a, 2-a, 3-a, 4-a 14.7 REFERENCES References book \uf0b7 Financial Statement Analysis - Martin Fridson. ... \uf0b7 International Financial Statement Analysis - Thomas Robinson. ... \uf0b7 The Finance Book - Stuart Warner & Si Hussain. ... \uf0b7 Financial Statements: Step by Step - Thomas Ittelson. 238 CU IDOL SELF LEARNING MATERIAL (SLM)","Website \u25cf https:\/\/cleartax.in\/s\/valuation-of- shares#:~:text=Valuation%20of%20shares%20is%20the%20process%20of%20 knowing%20the%20value,publicly%20can%20be%20known%20easily. \u25cf https:\/\/www.elearnmarkets.com\/blog\/share-valuation\/ \u25cf https:\/\/blog.ipleaders.in\/valuation-of-shares\/ 239 CU IDOL SELF LEARNING MATERIAL (SLM)"]