Earnings Capitalization Approach for Share Valuation

Valuation of Shares

Valuation of a share means finding the fair value of the share being considered. It is a process of understanding the value of a company’s shares. It indicates whether a share is overvalued or undervalued. The valuation is based on market supply and demand and is based on quantitative measures.

The value of shares of listed companies is easy to get. However, the companies that are not listed need to be carefully reviewed before judging their fair value.

When is the valuation of shares required?

• Valuation of shares is needed when one is buying or selling a business and wants to know the business value

• When someone needs a loan from the bank depending on the value of shares of his company in the market

• While establishing an employee stock ownership plan (ESOP)

• The value of a share is critical during acquisition, merger, reconstruction, amalgamation, etc.

• When the company shares are to be converted from one form to another, i.e., from preference to equity shares

• When the shares are held by a company that is into investment

• For taxation purposes, such as assessments under the gift tax or wealth tax acts

• In case of litigation or any other court cases, where share valuation may be legally required

• During the processes of compensating the shareholders, or the company is nationalized, share valuation may be required

Earnings Capitalization Approach

The Earnings Capitalization Approach has two different methods −

• Discounted Cash Flow (DCF) method

• Price Earning Capacity (PEC) method

DCF generally uses the projection of future cash flows to calculate the fair value of the share. When the data required for DCF is reasonably available, the method can be used.

PEC uses historical earnings and if an entity is not operating for a long time or has just started its operations, then PEC cannot be applied. PEC can only be used by an established entity. Startups and SMEs normally use the PEC method.

Companies usually use more complex analyses such as DCF. The value of each share is calculated depending on the profit of the company available for distribution. The profit can be obtained by deducting reserves and taxes from the net profit.

Note − The PEC method can only be used when the company has a long history to base the calculation. Only the established and long-held companies should use the PEC method.