5.6 Valuation of ordinary shares
Valuation of ordinary shares (common shares) involves various methods and models. Here’s an overview of some commonly used approaches:
Net Asset Basis: This valuation method calculates the value of ordinary shares based on the net assets (total assets minus total liabilities) of the company. It assumes that the shareholders’ equity represents the value of the company’s operations.
Price-Earnings Ratio Basis: The price-earnings (P/E) ratio is a widely used valuation metric. It compares the market price per share of a company’s ordinary shares to its earnings per share (EPS). By multiplying the company’s EPS by an appropriate P/E ratio (based on industry benchmarks or comparable companies), the value of ordinary shares can be estimated.
Capitalization of Earnings Basis: This method values ordinary shares by capitalizing the company’s earnings. It involves dividing the company’s earnings by an appropriate capitalization rate, which reflects the required rate of return for the shareholders. The resulting value represents the present value of the expected future earnings stream.
Gordon’s Model (Dividend Discount Model): This model values ordinary shares based on the expected future dividends. It calculates the present value of expected dividends by discounting them at the required rate of return (cost of equity) for the shareholders.
Finite Earnings Growth Model: This model considers a finite period of expected earnings growth and calculates the present value of the expected dividends during that period. It also includes a terminal value component, which represents the value of the company beyond the forecast period.
Super-Profit Model: This model focuses on excess profits or super-normal earnings generated by a company. It values ordinary shares based on the capitalization of these super-normal earnings, typically using a suitable capitalization rate.
Walter’s Model: Walter’s model assesses the value of ordinary shares by analyzing the relationship between the company’s retention ratio (proportion of earnings retained) and its return on equity (ROE). The model determines the optimal retention ratio that maximizes shareholder value.
Discounted Free Cash Flow (DCF): DCF valuation involves estimating the future free cash flows generated by the company and discounting them back to their present value using an appropriate discount rate. The resulting value represents the intrinsic value of the company, which can be used to estimate the value of ordinary shares.
Residual Income Model: The residual income model calculates the value of ordinary shares based on the company’s residual income, which is the excess of earnings over the cost of capital. It values shares as the present value of expected future residual income.
Economic Value Added (EVA) and Market Value Added (MVA): These relative measures assess the value created by a company. EVA calculates the excess return generated by the company, considering both operating profit and capital cost. MVA represents the difference between the market value of a company and its book value. Both measures can be used to assess the value of ordinary shares relative to the company’s performance and market expectations.
These methods and models provide different approaches to valuing ordinary shares. The choice of valuation method depends on factors such as the availability of data, the nature of the company, industry dynamics, and the investor’s preferences and assumptions. It’s common to use a combination of these methods to cross-validate the estimated value and obtain a more comprehensive view of the share’s worth.
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