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Valuation Of Ordinary Shares

Valuation of Ordinary Shares Assignment / Homework Help
Ordinary shares are also called as equity shares or common shares. Investors invest in equity shares with an expectation of dividends and growth in dividends and to benefit also through capital gains when they sell it. They typically purchase the common shares when the market value is lower than its true value and sell it when the market value is more than its true value, thus realizing a capital gain on the transaction. Some investors expect that the company would grow well in future and in anticipation of that retain their shares for a longer time. The value of an ordinary share is equal to the present value of all the expected future dividends over an infinite period. Symbolically, it can be expressed as:

   Valuation of ordinary share
Where:

P0 = Current value of common share

D1 = Dividend expected at the end of Year 1

r = Required rate of return on share

Dividend Valuation Models
Valuation of shares can be with respect to 1) Zero growth 2) constant growth and 3) Variable growth
  • Zero growth
  • As per this approach, it is assumed that the dividends are constant with non-growing feature. The value of the share would simply be the expected dividend divided by the required rate of return.

    P = D1 ⁄ r

  • Constant growth (Gordon Model)
  • As per this approach, the dividends are expected to grow at a constant rate. The value of the share as per this approach would be:

    P = D1 ⁄ (r-g)

    Where:

    g = Constant growth rate

  • Variable growth
  • As per this approach, the growth rate in dividend changes. The steps involved in valuing a share based on this approach would be:

    • Computation of value of cash dividends at the end of each year during the initial growth period.
    • Computation of present value of the dividends expected during the initial growth period.
    • Finding the value of the share at the end of the initial growth year, which would be the present value of all dividends expected from the end of initial growth year till perpetuity assuming a constant growth rate.
    • Adding of the present value components found in b) and c) and this would be the value of the share at the current date.


Other approaches for valuation of shares:

Apart from dividend valuation approaches discussed above, there are few other approaches to valuation of shares. They are:

  • Book value approach
  • Value of a share = Net worth ⁄ Number of outstanding equity shares.

  • Liquidation value approach
  • Liquidation Value Per share =
    (Value realized from liquidating all assets Amount payable to creditors and preference holders) divided by number of outstanding shares

  • Price Earnings Ratio approach
  • This reflects the amount investors are willing to pay for each rupee of earnings. = (1-b) ⁄ r (ROE x b)

    Where:
    1-b             =    dividend pay-out ratio
    r                 =    required rate of return
    ROE x b     =    expected growth rate

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