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Share Valuation: Understanding the True Value of Shares

The value of shares in the stock market is determined by the forces of demand and supply. When there is high demand for a company's shares, the share price increases. However, it is important to note that the share price does not necessarily represent the true value or fair value of the shares. To determine the true value of a company, one must consider its financial information. This information provides insights into the company's intrinsic value, which is crucial for making investment decisions. This process of determining the true value of a company is known as share valuation. In this article, we will delve into the concept of share valuation, how it is done, and the various methods involved.

Understanding Share Valuation

Share valuation is a quantitative technique used to determine the actual worth of a company. Analysts utilize the company's financial information, including current earnings, cashflows, assets, capital structure, and future cashflows, to ascertain the company's current value. By identifying the true value, analysts can determine whether the shares of a company are overvalued or undervalued, enabling informed investment decisions. When the market price of a share exceeds its intrinsic value, it is considered overvalued. Conversely, if the market price is lower than the intrinsic value, the shares are considered undervalued. Value investors or those practicing value investing consider undervalued shares to be excellent investment opportunities for long-term returns.

When is Share Valuation Required?

There are several circumstances that require share valuation:

1. Selling the company: The owners may want to know the true value of the company when considering a sale.

2. Mergers, acquisitions, or takeovers: Valuation is necessary for determining share value in such transactions.

3. Loan collateral: Banks may require a share valuation to provide a loan based on the shares held by the promoters.

4. Conversion of preference shares: Valuation helps determine the value of equity shares when converting preference shares.

5. Tax audits: Share valuation is crucial during tax audits.

6. Litigation: In the face of legal proceedings, considering the share valuation of the company is important.

7. Employee Stock Option Plan (ESOP): Valuation is necessary while implementing an ESOP.

Methods Used for Share Valuation

There are two primary types of stock valuation methods: absolute valuation and relative valuation.

Absolute Valuation:

This method utilizes the company's financials and fundamentals to determine its intrinsic value. Past financial data, such as cashflows, growth, and dividends, are analyzed to project future cashflows. Absolute valuation focuses solely on the financial data of a single company and does not consider the financials of other companies. Discounted cash flow (DCF), dividend discount model, and asset-based model are examples of absolute valuation techniques.

Relative Valuation:

Relative valuation involves comparing the company's valuation with that of similar companies. Analysts evaluate valuation multiples, such as price to earnings (P/E) ratio and dividend yield, of comparable companies to determine whether a company is overvalued or undervalued. If a company's P/E ratio is lower than that of its peers or the industry, it is considered undervalued. Conversely, if the P/E ratio is higher, it is considered overvalued. Relative valuation techniques include P/E ratio, price-to-book value (P/B), and enterprise multiple (EV/EBITDA).

Selecting the Best Stock Valuation Method

Choosing the appropriate valuation method depends on the specific qualities and strengths of each company. There is no universal rule to determine the best method. Different industries require different approaches. For instance, non-cyclical industries like pharma or FMCG that have predictable cashflows might benefit from the discounted cash flow method. On the other hand, banks or insurance companies, which have unpredictable cashflows, may find market multiples such as the P/E ratio more suitable. It is essential to consider the specific characteristics of a company and industry when deciding on the valuation method.

Factors Affecting Share Valuation

Several factors can influence the valuation of shares:

1. Company's financials: Profits, cashflows, dividends, and assets are vital factors in determining share valuation.

2. Market price: Relative valuation methods, such as P/E and P/B ratios, consider the company's share price, which is influenced by market sentiment and performance.

3. Economic conditions: Economic factors within a country can impact a company's short and medium-term performance, thus affecting its valuation.

Calculating the Value of Shares in a Private Company

Valuing ownership in a private company poses challenges due to the absence of readily available share prices in a public market. Two common approaches used are Comparative Company Analysis and Discounted Cash Flow (DCF) analysis. Comparative Company Analysis involves comparing a private company's valuation ratios to those of comparable public companies, using multiples like the P/E ratio. On the other hand, DCF analysis relies on the time-value of money principles to forecast future cashflows and calculate their present value. These methods offer insights into the potential future cash flows of a private company.

In conclusion, share valuation is an essential process for understanding the true value of shares. It involves analyzing financial information, considering various valuation methods, and evaluating a company's intrinsic value. By identifying whether shares are overvalued or undervalued, investors can make informed investment decisions.