Share Valuation

1.0 Introduction

Any shareholder who made an investment to an establishment expects certain returns whether it is in the form of dividend payment or capital growth or both (Ahn & Leung, 2006). In an efficient market, investors (both existing and potential) are assumed to perceive investment risk to commensurate with the required level of return. They will use available information about the future plans of the company to formulate their expectations about future dividends (Ohlson and Juettner-Narouth, 2005)and capital growth. Thus, the cost of equity is equivalent to the rate of return which investors expect to gain on their equity holdings in relation to the level of risk involved.

On the other hand, the most common reason to have a company or share valuation by investors is when a company requires to raise new funds. New funds raised can then be channelled to either establish a new company, expansion of current operations or undertake a project. A company might raise new funds through capital markets, bank borrowings, government sources and venture capital.

Hence, a company which intends to raise funds through capital market must consider how investors would appraise the company when assessing the returns they can expect in view of the risks they are taking.

1.1 Background

1.1.1 Valuation

The company's value is based on an expectation of its ability to generate future cash flow. The organisation value is the value of the future cash flow that is attributable to both the debt and the equity holders within the business.

1.1.2 Company

Most of the examples and elaboration mentioned in this paper refers to public listed firms with equity quoted or listed in the share market.

1.1.3 Shares or Stock

Shares, stock or securities refers to the equity or ordinary shares of the firm.

Many models and methodologies are available to value a company or its stocks. In fact, it is mentioned that company and shares valuation is an art. There can never be a definite way to evaluate a company value. Even discounted cash flow analysis has been used to value existing companies. This paper aims to examine the various valuation models and methodologies employed including Dividend Valuation Model, Earnings Model, Pre Cash Flow Model and Asset Valuation Model.

2.0 Dividend Valuation Model

The dividend valuation model states that the value of a security equals the future expected returns from that security, discounted at the security holders' required rate of return. It recognises that shares are perpetuities. Individual investors may buy or sell them, but only very exceptionally are they redeemed. In this regard, the model also takes on the assumptions of perpetual dividend payments and therefore an infinite business. Both assumptions are stated unrealistic, but serves as a basis for calculation.

2.1 Limitations of this model despite its feasibility in calculation:

2.1.1 All dividends and prices used are mere estimation of the future

2.1.2 It is assumed that investors are wise and would make rational decision about the share transaction based on the financial valuation

2.1.3 It inherits the assumptions of present value approach

2.1.4 Dividend are paid annually, consistently and equally every year until infinity.

3.0 Dividend Growth Models

Using historic data, the dividend growth rates is estimated subjectively by individual investors. Alternatively, earnings may be used instead of dividends to estimate growth from historic trends (Koller and Williams, 2002). Earnings represents a good indicator of the company's long-term ability to pay dividends and therefore in estimating the rate of growth of future dividends, the rate of growth of the underlying profits must also be considered.

The Gordon growth model is based on the premise that the higher the company's retentions level, the greater the potential rate of growth. It follows from looking at the rate of growth of retained profits. The annual growth in dividend is estimated to be equivalent to the multiplication of accounting rate of return and the proportion of funds retained by the company each year.

However, one of the major weakness of this model is its reliance on accounting profits (Conesa, Martinez, 2004) and the assumption that the rate of return and proportion of funds retained will remain constant (Harper, 2002). Inflation can substantially distort the accounting rate of return by the company each year.

4.0 Earnings Model

4.1 The Price Earnings Ratio (P/E Ratio)

In Malaysia and in most of the South East Asia, Price Earnings (P/E) ratio is the most important yardstick for assessing the relative worth of share and to look at the values of similar companies. It is calculated based on the following formula:

The value of the P/E ratio reflects the market's appraisal of the shares' future prospects. In other words, if one company has a higher P/E ratio than another it is because investors either expect its earnings to increase faster than the other's or consider that it is a less risky company or in a more secure industry.

The P/E ratio is, simply, a measure of the relationship between the market value of a company's shares and the earnings from those shares. It is an important ratio because it relates two key considerations for investors, the market price of a share and its earnings capacity. It is significant only as a measure of this relationship between earnings and value.

4.2 Changes in EPS: The P/E Ratio and the Share Price

Another approach to assessing what share prices ought to be, which is often used in practice, is a P/E ratio approach. It is a commonsense approach to share price assessment, although not as well founded in theory as the dividend valuation model.

For example, the relationship between the EPS and the share price is measured by the P/E ratio. There is no reason to suppose, in normal