(Rs lakh)

Liabilities Amount Assets Amo

unt

Share capital Fixed

assets

Rs

150

40,000 11%

Preference shares of

Rs 100 each, fully

paid-up

40 Less:

Depreciati

on

30 120

1,20,000 Equity shares

of Rs 100 each, fully

paid-up

120 Current

assets:

Profit and loss account 23 Stocks 100

10% Debentures 20 Debtors 50

Trade creditors 71 Cash and

bank

10 160

Provision for income

tax

8 Preliminar

y

expenses

2

282 282

Additional Information:

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(i) A firm of professional valuers has provided the

following market estimates of its various assets: fixed

assets Rs 130 lakh, stocks Rs 102 lakh, debtors Rs 45

lakh. All other assets are to be taken at their balance

sheet values.

(ii) The company is yet to declare and pay dividend on

preference shares.

(iii) The valuers also estimate the current sale proceeds

of the firm's assets, in the event of its liquidation: fixed

assets Rs 105 lakh, stock Rs 90 lakh, debtors Rs 40

lakh. Besides, the firm is to incur Rs 15 lakh as

liquidation costs.

You are required to compute the net asset value per

share as per book value, market value and liquidation

value bases.

Solution

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Determination of Net Asset Value per Share

(Rs. Lakh)

(i) Book value basis Rs.

120

Fixed assets (net)

Current assets:

Stock 100

Debtors 50

Cash and Bank 10 160

Total assets 280

Less : External liabilities:

10% Debentures 20

Trade Creditors 71

Provision for taxation 8

11% Preference Share capital 40

Dividend on preference shares (0.11 x

Rs. 40 Lakh)

4.4 143.4

Net assets available for equityholders 136.6

Divided by the number of equity

shares (in lakh)

1.2

Net assets value per share (Rs.) 113.83

(ii) Market value basis

Fixed assets (net) 130

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Current assets:

Stock 102

Debtors 45

Cash and Bank 10 157

Total assets 287

Less: External liabilities (as per

details given above)

143.4

Net assets available for equityholders 143.6

Divided by the number of equity

shares (in lakh)

1.2

Net assets value per equity share (Rs.) 119.67

(iii) Liquidation value basis

Fixed assets (net) 105

Current Assets:

Stock 90

Debtors 40

Cash and Bank 10 140

Total assets 245

Less : external liabilities (listed

above);

143.4

Less : Liquidation costs 15.0

Net assets available for equityholders 86.6

Divided by the number of equity 1.2

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shares (in lakh)

Net assets value per equity share (in

Rs.)

72.17

The asset based approach is intuitively appealing in that

it indicates the net assets backing per equity share.

However, the approach ignores the future earnings/cash

flow generating ability of the company's assets. In fact,

the assets acquisition by business firms are not an end

in themselves; they are means to an end. The end is

value maximization and firms acquire assets for the

purpose of creating value. The earning based approach

reckons this perspective.

Earnings Based Approach to Valuation

The earnings approach is essentially guided by the

economic proposition that business valuation should be

related to the firm's potential of future earnings or cash

flow generating capacity. This approach overcomes the

limitation of assets-based approach, which ignores the

firm's prospects of future earnings and ability to

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year.

Revenue and cost estimates in respect of the new

product are as follows: (Rs lakh)

Sales 60

Material Cost 15

Labour Cost (additional) 10

Allocated fixed costs 5

Additional fixed costs 8

From the given information, compute the value of the

business, given that capitalisation rate applicable to

such business in the market is 15 per cent.

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Solution

TABLE 1 Valuation of Business

(Rs lakh)

Profit before tax (Rs. 65 lakh / (1-

0.35)

Rs.

100

Less : Extraordinary income (not

likely to accrue in future)

(10)

Add: extraordinary loss (non-

recurring in nature)

3

Sales Rs. 60

Less: Incremental costs

Material Costs Rs. 15

Labour Costs 10

Fixed costs (additional) 8 33 27

Expected profits before taxes 120

Less: Taxes (0.35) 42

Future maintainable profits after

taxes

78

Relevant capitalization factor 0.15

Value of business (Rs 78 lakh /

0.15)

520

Some useful insights into estimate of capitalisation rate

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can be made by referring to the Price earnings (P/E)

ratio. The reciprocal of the P/E ratio is indicative of the

capitalisation factor employed for the business by the

market. In Example 32.2, the P/E ratio is approximately

6.67 (1/0.15). The product of future maintainable

profits, after taxes, Rs 78 lakh and the P/E multiple of

6.67 times, yield Rs 520 lakh. Given the fact that P/E

ratio is a widely used measure, it is elaborated below.

Price Earnings (P/E) Ratio The P/E ratio (also known as

the P/E multiple) is the method most widely used by

finance managers, investment analysts and equity

shareholders to arrive at the market price of an equity

share. The application of this method primarily requires

the determination of earnings per equity share (EPS).

The EPS is computed as per Equation.

EPS = Net earnings available to equity shareholders

during the period

Number of equity shares outstanding during the period.

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The net earnings/profits are after deducting taxes,

preference dividend, and after adjusting for exceptional

and extraordinary items (related to both incomes and

expenses/losses) and minority interest. Likewise,

appropriate adjustments should be made for new equity

issues or buybacks of equity shares made during the

period to determine the number of equity shares.

The EPS is to be multiplied by the P/E ratio to arrive at

the market price of equity share (MPS).

MPS = EPS x P/E ratio ($2.6)

A high P/E multiple is suggested when the investors are

confident about the company's future

performance/prospects and have high expectations of

future returns; high P/E ratios reflect optimism. On the

contrary, a low P/E multiple is suggested for shares of

firms in which investors have low confidence as well as

expectations of low returns in future years; low P/E

ratios reflect pessimism.

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The P/E ratio may be derived given the MPS and EPS.

P/E ratio = MPS/EPS

The future maintainable earnings/projected future

earnings should also be used to determine UPS. It

makes economic sense in that investors have access to

future earnings only. There is a financial and economic

justification to compute forward or projected P/E ratios

with reference to projected future earnings, apart from

historic P/E ratios. This is all the more true of present

businesses-that operate in a highly turbulent business

environment. Witness in this context, the following: "In

a dynamic business world, a firm's past earnings record

may not be an appropriate guide to its future earnings.

For example, past earnings may have been exceptional

due to a period of rapid growth. This may not be

sustainable in the future.

The P/E ratios should, however, be used with caution as

the published P/E multiples are normally based on the

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risk and growth.

Example For facts in Example, determine the

market price per equity share (based on future

earnings). Assuming:

(i) The company has 1,00,000 11% Preference shares

of Rs 100 each, fully paid-up.

(ii) The company has 4,00,000 Equity shares of Rs

100 each, fully paid-up.

(iii) P/EE ratio is 8 times.

Solution

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Future maintainable profits after taxes

Less: Preference dividends (1,00,000 x Rs

11)

Earnings available to equity-holders

Divided by number of equity shares

Earnings per share (Rs 67 lakh/4 lakh)

Multiplied by P/E ratio (times)

Market price per share (Rs 16.75 x 8)

Rs.

78,00,000

11,00,000

67,00,000

4,00,000

16.75

8

134

To conclude, the P/E ratios should be used/interpreted

with caution and care. In particular, die investors should

focus on prospective/future P/E ratios, risk and growth

attributes of business and comprehensive company

analysis with a view to have more authentic and

credible valuation.

Earnings Measure on Cash Flow Basis (DCF Approach)

The P/E ratio approach, as a measure of valuation of

equity shareholders wealth, is essentially based on

accounting profits/earnings. Normally, such earnings

Determination of Market Price of Equity Share

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