Page 282 - DCOM205_ACCOUNTING_FOR_COMPANIES_II

Unit 12: Valuation of Shares

(iii) On the partly paid up shares, the investors will expect a higher yield than that of fully Notes
paid up shares. Therefore, on the partly paid up shares the normal rate of return will
be higher. Increase of 0.25% to the normal rate of return is considered reasonable.
(iv) Investors also want adequate safety against their investment. If net tangible assets
per share are twice or thrice the paid up value of the share of a company, investors
will be satisfied with a lower rate of return or else desire a higher rate of return.
(v) If a company transfers a major part of profits to its reserves and distributes to its
shareholders as dividend, in spite of being a lower rate of dividend, it will attract
more investors.
Thus, at the time of valuation of shares, under this method, if any one of the above factors is in
operation, normal rate of return should be adjusted accordingly.

Notes Earning method is also known as Yield Basis Method or Market Value Method and
Income Valuation Method.

(b) Valuation of Share Based on Actual Rate of Earning: This method is an improvement
over the yield value method. Generally, some companies distribute only a part of their
profits in the form of dividend to the shareholders and balance of profits is transferred to
its reserve funds. And these reserve funds (accumulated profits) are likely to be distributed
sooner or later in the form of bonus shares to the shareholders. Therefore, it would be
more appropriate to value the shares based on the actual earning rather than the dividend
declared by the company. Particularly for those investors who are intended to acquire
the controlling interest (majority of shares) in a company, the valuation of their holdings
(shares) should be based on the actual earning. The formula, for calculating the value of
shares on the basis of actual rate of earning is as under –

Actual Rate of Earning
Value per Share = ×Paidup Value of a Share
Normal Rate of Return

Actual Profit Earned
Actual Rate of Earning = × 100
Effective Capital Employed
Actual Profit Earned: To calculate the actual profit earned, average annual profits should
be taken after tax, depreciation and transfer to reserves. Profits earned should accord the
effective capital employed. If debentures and preference share capital are included in the
capital employed, interest on debentures and dividend on preferences shares should not be
deducted from the profits earned. And if debentures and preference share capital are not
included in the capital employed, profit earned should be taken after deducting the interest
on debentures and dividend on preference shares. Income on non-trading assets is also not
included in profits, but non-recurring items are allowed.

Effective Capital Employed: To ascertain the effective capital employed, all tangible assets
(excluding goodwill and non-trading assets) are taken and then external liabilities are
subtracted. Debentures and preference share capital may be deducted from the total tangible
assets as per profits (as explained above). All the tangible assets should be taken at their
book values. Alternatively, effective capital employed can be calculated by totalling the
equity share capital and reserve funds (accumulated profits). Debentures and preference
share capital may be included according to the profit calculations.

LOVELY PROFESSIONAL UNIVERSITY 277