VALUATION OF SHARES AND BUSINESS

[Mr. M. GOVINDARAJAN]

Valuation is a devise to assess the worth of the enterprise.  A share is a bundle fo rights like rights like right to elect directors, to vote on resolutions of the company, share in the surplus, if any, on liquidation etc.,   The valuation of shares is required to be done in the following circumstances:

• Assessments under Wealth Tax Act;
• Purchase f a ‘block of shares’ which may or may not give the holder thereof a controlling interest in the company;
• Formulation of schemes of amalgamation, etc.,
• Acquisition of interest of dissenting shareholders under a scheme of reconstruction;
• Conversion of shares;
• Advancing a loan on the security of shares.

If the transactions involve a small number of shares, which are quoted on the stock exchange, normally the price prevailing on the stock exchange is accepted.  The valuation of company shares is a highly technical matter which requires considerable knowledge, experience and expertise in the job.  Valuation of experts is called for when the parties involved in the transaction fail to arrive at a mutually acceptable value or the agreements or Articles of Association etc., provide for valuation by experts.

The valuation by a valuer becomes necessary when-

• Shares are unquoted;
• Shares relate to private limited companies;
• Courts so direct;
• Articles of Association so provide;
• Relevant agreements so provide;
• Statute so requires.

In ‘CWT V.  Mahadeo Jalan’ – 1972 (9) TMI 7 - SUPREME Court the Supreme Court elaborately discussed the valuation of shares in different situations.  The Supreme Court observed that an examination of the various aspects of valuation of shares in a limited company would lead to the following conclusion:

• Where the shares in a public limited company are quoted on the stock exchange and there are dealings in them, the price prevailing on the valuation date is the value of shares;
• Where the shares are of a public limited company which are not quoted on a stock exchange or of a private limited company, then value is determined by reference to the dividends, if any, reflecting the profit earning capacity on a reasonable commercial basis.   But, where they do not, then the amount of yield on that basis will determine the value of the shares.   In other words, the profits which the company has been making and should be marking will ordinarily determine the value;
• The dividend and earning method or yield method are not mutually exclusive; both should help in ascertaining the profit earning capacity as indicated above.   If the results of the two methods differ, an intermediate figure may have to be computed by adjustment of unreasonable expenses and adopting a reasonable proportion of profits;
• In the case of a private limited company also where the expenses are incurred out of all proportion to the commercial venture, they will be added back to the profits of the company in computing the yield.  In such companies the restrictions on share transfers will also be taken into consideration as earlier indicated in arriving at valuation;
• Where the dividend yield and earning method break down by reason of the company’s inability to earn profits and declare dividends, if the set back is temporary, then it is perhaps possible to take the estimate of the value of the shares before set back and discount it by a percentage corresponding to the proportionate fall in the price of quoted shares of companies which have suffered similar reverses;
• Where the company is ripe for winding up, then the breakup value method determines that what would be realized by that process.

The Supreme Court, in setting out the above principles, had not tried to lay down any hard and fast rule because ultimately the facts and circumstances of each case, the nature of the business, the prospects of profitability and such other considerations will have to be taken into account as will be applicable to the facts of each case.

Valuation helps in determining the value of shares of the acquired and acquiring company to safeguard the interests of the shareholders of both the companies.  The process of arriving at the value should include a detailed and comprehensive analysis which takes into account a range of factors including the past, present and most importantly, the future earnings and process of the company, an analysis of its mix of physical and intangible assets and the general economic and industry conditions.

The other salient factors include-

• The stock exchange price of the shares of the two companies before the commencement of negotiations or the announcement of the bid;
• Dividend paid on the shares;
• Relative growth prospects of the two companies;
• In case of equity shares, the relative gearing of the shares of the two companies;
• Net assets of the two companies;
• Voting strength in the merged enterprise of the shareholders of the two companies.
• Past history of the prices of shares of the two companies.

The following four factors are to be kept in mind in the valuation of shares-

• Capital cover;
• Yield;
• Earning capacity; and
• Marketability.

For arriving at the fair value of shares, three well known methods are to be applied-

• The manageable profit basis method;
• The net worth method or the break up value method; and
• The market value method.

The following are the methods of valuation of the business-

• Value based on assets, such as book value, replacement cost, appraised value, exchange earnings etc.,
• Open market valuation;
• Valuation based on earnings, such as share exchange ratio, discounted cash flows etc.,
• Valuation based on super profits.

The Companies Act requires to get the approval of the High Court in case of mergers amalgamation.  The High Court may accord the sanction or reject the sanction.  In the matter of ‘Carron Tea Company Limited’ – (1966) 2 Comp LJ: 278 (Cal), the High Court held that although the question of valuation of shares and fixation of exchange ratio is a matter of commercial judgment and the court should not sit in judgment over it, yet the court cannot abdicate its duty to scrutinize the scheme with vigilance.  It is not expected of the Court to act as a rubber stamp simply because the statutory majority has approved the scheme and there is no opposition to it.  The Court is not bound to treat the scheme as a facit accompli and to accord its sanction merely upon a casual look at it.  It must still scrutinize the scheme to find out whether it is reasonable arrangement which can, by reasonable people conversant with the subject, be regarded as beneficial to those who are likely to be affected by it.  Where there is no opposition, the court is not required to go deeper.  However, when there is opposition, the court not only will, but must go into the question and if it is not satisfied about the fairness of the valuation, it would be justified in refusing to accord sanction to the scheme.

In ‘Bank of Baroda V. Mahindra Ugine Steel Co. Limited’ – 1975 (9) TMI 95 - HIGH COURT OF GUJARAT  the High Court held that the jurisdiction of the High Court in inquiring into the fairness of the exchange ratio cannot be ousted by vote of majority shareholders on the ground that valuation of shares is a matter of commercial judgment.

In ‘Hindustan Lever Employees Union V. Hindustan Lever Limited’ – 1994 (10) TMI 211 - SUPREME COURT OF INDIA  the Supreme Court held that the court’s obligation is to satisfy that the valuation was in accordance with law and the same was carried out by an independent body.

There is no method of valuation is absolutely correct.   Hence a combination of all or some may be adopted.  If possible, the seller should evaluate his company before contacting potential buyers.  In fact, it would be wiser for companies to evaluate their business on regular basis to keep them aware of its standing in the corresponding industry.  Merger and amalgamation deals can take a number of months to complete during which time valuations can fluctuate substantially.  Hence provisions must be made to protect against such swings.