Equity Valuation

Equity shares can be described more easily than fixed income securities. However, they are more difficult to analyze. Fixed income securities typically have a limited life and a well defined cash flow stream. Equity shares have neither. While the basic principles of valuation are the same for fixed income securities as well as equity shares, the factors of growth and risk create greater complexity in the case of equity shares.

As our discussion of market efficiency suggested, identifying mis-priced securities is not easy. Yet there are enough chinks in the efficient market hypothesis and hence the search for mis-priced securities cannot be dismissed out of hand. Moreover, remember that it is the ongoing search for mis-priced securities by an army of equity analysts that contributes to a high degree of market efficiency.

Equity analysts employ two kinds of analysts, viz., fundamentals analysis and technical analysis. Fundamental analysts assess the fair market value of equity shares by examining the assets, earnings prospects cash flow projections, and dividend potential. Fundamental analysts differ from technical analysts who essentially rely on price and volumes trends and other market indicators to identify trading opportunities.

Balance Sheet Valuation:

Analysts often look at the balance sheet of the firm to get a handle on some valuation measures. Three measures derived from the balance sheet are: book value, liquidation value, and replacement cost.

Book value:

The book value per share is simply the net worth of the company (which is equal to paid up equity capital plus reserves and surplus) divided by the number of outstanding equity shares. For example, if the net worth of Zenith Limited is Rs 37 million and the number of outstanding equity shares of Zenith is 2 million, the book value per share works out to Rs 18.50 (Rs 37 million divided by 2 million).

How relevant and useful is the book value per share as a measure of investment value? The book value per share is firmly rooted in financial accounting and hence can be established relatively easily. Due to this, its proponents argue that it represents an objective measure of value. A closer examination, however quickly reveals that what is regarded as objective is base on accounting conventions and policies which are characterized by a great subjectivity and arbitrariness. An allied and a more powerful criticism against the book value, measure, is that the historical balance sheet figures on which it is based are often very divergent from current economic value. Balance is regarded as a good proxy for true investment value.

Liquidation Value:

The liquidation value per share is equal to:

Value realized from liquidating — Amount to be paid to all creditors
all the asserts if the firm and preference shareholders
Number of outstanding equity shares

To illustrate assume that Pioneer Industries would realize Rs 45 million from the liquidation of units assets and pay Rs 18 million to its creditors and preference shareholders in full settlement their claims. If the number of outstanding equity shares of Pioneer is 1.5 million the liquidation value per share works out to:

Rs 45 million – Rs 18 million = Rs 18
1.5 million

While the liquidation value appears more realistic than the book value, there are two serious problems in applying it. First, it is very difficult to estimate what amounts would be realized from the liquidation of various assets. Second, the liquidation value does not reflect earning capacity. Given these problems, the measure of liquidation value seems to make sense only for firms which are better dead than alive –such firms are not viable and economic values cannot be established for them. —

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