The valuation of securities – practical issues

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1 Introduction

We have looked at the theoretical valuation of securities but for various reasons the theory does not work perfectly in practice.

In this chapter we look at the limitations of the theory and consider practical issues.

2 Limitations of the dividend valuation model

Although expected future dividends and the shareholders required rate of return certainly do impact upon the market value of shares, it would be unrealistic to expect the theory to work perfectly in practice.

2.1 Main reasons for this include:

• The stock exchange is not perfectly efficient, and therefore the market value of a share may be distorted from day-to-day by factors such as rumours about a takeover bid.

• In practice, market values do not change instantly on changes in expectations – the speed at which the market value changes depends on the volume of business in the share.

• The model only deals with constant growth in dividends. In practice this may not be the case. However, do appreciate that the growth used in the model is the future growth that shareholders are expecting – this is perhaps more likely to be at a constant rate. The big problem is determining the rate of growth that shareholders expect! It is clearly impossible to ask them, and any estimate that we make for our calculations is only an estimate and could of course be completely different from the rate of growth that shareholders are in fact expecting.

3 Financial Accounts based valuations of equity

Other common, practical approaches to valuing shares in unquoted companies are:

3.1 Net assets basis

On this approach the value per share is calculated as:

A problem is on what basis to value the net assets:

• realisable value – this would only be sensible if the company was about to be wound up

• replacement value – this would be more sensible from the point of view of another company considering making an offer for the shares in our company. However, it would be ignoring the value of any goodwill.

• Book value – this is normally of little relevance, since the book values of assets are unlikely to even approximate to the actual values.

3.2 Earnings basis

• This approach uses the price earnings ratio of a similar quoted company.

• For example, if the latest set of accounts for a publishing company show earnings per share of 50c, and quoted publishing companies currently have PE ratios of 18, then the price per share for our company would be 50c × 18 = $9