Shares, in the simplest way, are basically units of the company’s overall valuation. A Share is an entity that can be bought or sold at a specific monetary value. When you buy a share(s), you basically own a percentage stake in the company that share belongs to. You also become a “shareholder” in the company as soon as you buy shares of the company.
Let’s try to understand the concept through an example.
For instance, you own a company named “RockFella Music“. You are the single owner of the company that records music albums of the singers in your state. Now, you want to try “Bollywood” and will need capital of ₹10 Crore for that!
But, you got no money to materialize this expansion plan.
So, what do you do?
You hire an investment banking firm to help you out with your business’ valuation. After going through the financial statements of the company, they value “RockFella Music” at ₹50 Crore. They also help you in spreading this valuation over a total of 50 Lakh Shares, with each share valued at ₹100.
Now, you spread the word in order to sell 10 Lakh Shares out of the total (20% of your company’s stake) and let’s say, 100 investors, end up buying 10,000 shares each and investing ₹10 Lakh each in your company. Each of these “shareholders” ends up getting 0.2% of stake in “RockFella Music”.
Moving ahead, assuming your company was able to hit well in the tinsel town and company valuation in a matter of 2 years reached ₹200 Crore. When that happened, each of the investor’s initial investment of ₹10 Lakh each reaches ₹40 Lakh as well.
That is the whole concept of Share Market and how Shares actually drive a company’s performance and your investments in parallel.
Primarily, there are 3 ways by which shares are valued:
Shares Valuation – Cost Approach
Cost Approach considers the tangible assets of the company including the manufacturing plants/real estate properties, pieces of equipment, physical machines etc. The company valuation is done based on the total valuation of all such assets.
Company’s book of net assets over net liabilities is calculated and then the net capital value is calculated. In order to find the share value using the cost approach, the net capital value is then divided by the total shares outstanding. Although with this approach the share value is calculated, there is a certain limitation with this approach.
Cost approach does not consider any intangible assets linked to the company including the cost of the brand value itself.
Shares Valuation – Market Approach
Few businesses choose to use the market approach in order to calculate the valuation of the shares. This is a relatively complex approach and requires different parameters in order to reach a specific number. The price of the stock is divided by EPS or Earnings per share which gives the P/E ratio.
Higher the P/E ratio, higher is the valuation of the company. It also depends on the industry type as the P/E ratio varies for companies coming from different business domains.
Shares Valuation – Income Approach
Thirdly, Income Approach is one of the straightforward ones when it comes to calculating shares valuation. In this method, the sum of the total potential income of the company from different revenue streams is calculated first. Now, either this cash flow can stay as is or it can decrease as well.
Depending on the way, it is kept – the resulting figure is divided by the number of outstanding shares of the company and the value of a share is calculated.
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