Hello, What is the method of valuation of shares? Methods of this evaluation depend on that purpose. In financial accounting, an asset is a resource owned by any business or economic entity. It is anything that can be owned or controlled to produce value. And which is held by an economic entity? And which can produce positive economic value?
A shareholder is a person or entity that legally owns one or more shares of stock in a public or private corporation. Shareholders may be referred to as members of a corporation. Which requires evaluation. Generally, there are three ways of valuing shares. Let us throw light on these 3 ways. The definition & Example is also included.
Table of Contents
1. Method of valuation of net asset shares.
Under this method, the net worth of a company’s assets is divided by the number of shares to arrive at the value of each share. To determine the net worth of assets, it is necessary to estimate the value of assets and liabilities. Goodwill, as well as non-traded assets, should also be included in the total assets. According to this method, the following points should be considered while pricing the shares:
Goodwill should have true value.
- Fictitious assets such as initial expenses, discounts on the issue of shares and debentures, accumulated losses, etc. should be eliminated.
- Immovable properties should be taken at their actual value.
- Provision for bad debts, depreciation, etc. should be considered.
- All unchanged assets and liabilities (if any) should be considered.
- Floating assets should be taken at the market prices.
- External liabilities such as miscellaneous creditors, bills payable, debt, debentures, etc. should be deducted from the value of assets to determine the net worth.
The net worth of the assets is determined so as to find out the value of the share divided by the number of equity shares. Thus the price per share can be determined using the following formula:
Price per Share = (Net Assets-Share Capital Share) / Number of equity shares
2. The yield or market value method of valuation of shares
The expected rate of return in investment is represented by the yield. The term “rate of return” refers to the return that a shareholder earns on his investment. In addition, it can be classified as (A) rate and dividend rate. In other words, yield can be yield and dividend yield.
A. Earnings Yield
Under this method, shares are valued based on estimated earnings and the normal rate of return. The price per share is calculated by applying the following formula:
Price per share = (normal rate of earnings / normal rate of return) X-paid value of equity share
Expected rate of earnings = (Profit after tax / paid value of equity share) x 100
B. Dividend Yield
Under this method, shares are valued on the basis of the expected dividend and the normal rate of return. The value per share is calculated by applying the following formula:
Expected rate of dividend = (profit available for dividend/paid-up equity share capital) X 100
Value per share = (Expected rate of dividend/normal rate of return) X 100
3. Acquiring the ability to evaluate shares
Under this method, the price per share is calculated based on the company’s disposable profit. Disposable profit is found by deducting reserves and taxes from net profit. The following steps apply to the determination of low-income potential per share:
Step 1: To find out the profit available for dividend
Step 2: To find out the capitalized value
Capitalized Value =( Profit available for equity dividend/Normal rate of return) X 100
Step 3: To find out the value per share
Value per share = Capitalized Value/Number of Shares
4. Intrinsic Value
The intrinsic value is the difference between the underlying price and the strike price, to the extent that it is in favor of the option holder. For a call option, the option is in-the-money if the underlying price is greater than the strike price, then the intrinsic value is the underlying price which is the strike price.
For the put option, the option is in-the-money. If the strike price is greater than the underlying price, then the intrinsic value is the underlying price of the strike price. Otherwise, the intrinsic value is zero.
In simple words, it is the price by which the market is already available. If you are holding the NIFTY 5000 Call (Bullish / Long) option. And NIFTY is at 5050 levels, so you already have (A) 50 profit if the option ends today. These are (B) intrinsic values of 50 options.
Conversely, if you have a put option. And NIFTY is less than the strike price. So your option has an intrinsic value equal to the difference between the strike price and the NIFTY value. So,
= Current Stock Price – Strike Price (Call option)
= Strike Price – Current Stock Price (Insert Option)
5. Time value
The option premium is always higher than the intrinsic value. This is making the option writer/seller to risk extra money. This is called the time value.
Time value is that amount. The option trader is paying for a contract above its intrinsic value, with the belief that a favorable change in the price of the underlying asset will increase the contract price before the expiration. Obviously, the longer the time until the contract expires, the longer the time value will be. So,
Time Value = Option Premium – Intrinsic Value
There are many factors that determine the option premiums. These factors affect the premium of the option with varying intensity. Some of these factors are listed here:
Price of the underlying: Any fluctuation in the price of the underlying (stock/index/commodity) obviously has the largest impact on the premium of an option contract. An increase in the underlying price increases the premium of the call option and decreases the premium of the put option. The reverse is true when the underlying price decreases.
Strike price: How far is the strike price from spot also has an impact on the option premium. Say, if NIFTY goes from 5000 to 5100 the premium of 5000 strikes and of 5100 strikes will change a lot compared to a contract with a strike of 5500 or 4700.
Time till expiry: Lesser the time to expiry, option premium follows the intrinsic value more closely. On the expiry date Time Value approaches zero.
The volatility of underlying: Underlying security is a constantly changing entity. The degree by which its price fluctuates can be termed as volatility. So a share which fluctuates 5% on either side on a daily basis is said to have more volatility than let’s say a stable blue-chip share whose fluctuation is more benign at 2–3%. Volatility affects calls and puts alike. Higher volatility increases the option premium because of the greater risk it brings to the seller.
Apart from above, other factors like bond yield (or interest rate) also affect the premium. This is due to the fact that the money invested by the seller can earn this risk-free income in any case and hence while selling option; he has to earn more than this because of the higher risk he is taking.
Because the values of option contracts depend on a number of different variables in addition to the value of the underlying asset, they are complex to value. There are many pricing models in use, although all essentially incorporate the concepts of rational pricing, moneyness, option time value, and put-call parity.
- Amongst the most common models are:
- Black–Scholes and the Black model
- The binomial options pricing model
- Monte Carlo option model
- Finite difference methods for option pricing
- Other approaches include:
- Heston model
- Heath–Jarrow–Morton framework Variance gamma model (see variance gamma process)
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Business management expert and Leadership Consultant and Business Coach, who writes her blog, Jay’s Trends, focused on helping small business owners understand trends in Business management. Other posts by Jayprakash Prajapati»