J. K.

SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

CHAPTER 9 VALUATION OF SHARES / GOODWILL

PART A: THEORY
This Chapter includes
- Valuation of shares - Special factors for valuation factor of
- Methods of valuation of shares – net asset shares
basis or intrinsic value method, yield basis, - Valuation of intangible : brand, goodwill
valuation based on rate of return, valuation and IPRs
basis and productivity

Chapter at a Glance

Topic Important Highlight

1. Need for valuation of The necessity for valuation of shares arises inter alia in the
shares following circumstances :
i) Purchase of a book of shares which may or may not give the
holder thereof a controlling interest in the company.
ii) Purchase of shares by employees of the company where the
retention of such shares is limited to the period of their
employment
iii) Formulation of schemes of amalgamation, absorption, etc
iv) Acquisition of interest of dissenting shareholders under a
scheme of reconstruction
v) Compensating shareholders on the acquisition of their shares
by the Government under a scheme of rationalization
vi) Conversion of shares, say, conversion of preference shares
into equity
vii) Advancing a loan on the security of shares
2. Methods of valuation of shares
(a) Net assets basis of The method relating to net asset basis may take various forms
intrinsic value depending upon circumstances :
method
i) Break-up value method (or liquidation value method)
ii) Appraised value method; and
iii) Book value method
Depending on the circumstances of the case, goodwill may or may
not be included. Goodwill comes in for distinct consideration only
when the number of shares involved is large giving to the holder a
measure of control. Normally, earning represents the result of
application of all assets of every description in the business,
whether it is plant and machinery or goodwill or patent or know-
how, for a small number of shares in a going concern, earning is
the only appropriate basis.
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

(b) Yield basis i) Valuation based on rule of return

ii) Valuation based on rate of dividend
Value of share
Possible rate of dividend x paid up value per share
normal rate of dividend

dividend (in rupees) per share x 100

normal rate of dividend
possible rate of dividend
Total profit available for dividend x 100
Total paid up equity capital

iii) Valuation based on rate of earning :

Value of share
Rate of earning x paid-up value per share
Normal rate of earning
Rate of earning = actual profit earned x 100
Capital employed
iv) Valuation based on price earnings ratio :
Market value of share = price earnings ratio x earning per share
Earning per share
= profit available for equity shareholders
Number of equity shares
Price earnings ratio = market value per share
Earnings per share
v) Capitalization factor
Capitalization factor = 100______
Normal rate of return
3. Special factors for a) Importance of the size of the block of shares
valuation of shares b) Restricted transferability
c) Dividends and valuation
d) Bonus and right issues
4. Valuation of These are valued on yield basis in a going concern. Compared to
preference shares equity shares, the rate of return in preference shares would be,
generally, lower because of greater safety. With fluctuations in the
normal rate of return in respect of preference shares, the value of
preference share will fluctuate but in the opposite direction, i.e., if
the normal rate of return increases, the value tends to diminish.
5. Intangible assets Following features of intangible assets :
i) It is non-physical in nature
ii) It gives the specific rights to the holders over several future
years
iii) It is possible for multiple uses at the same time
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

iv) It creates future value

v) It is identifiable as non-monetary asset
vi) It has limited ability to protect property rights
vii) Investment in intangible assets is basically risky
6. Recognition of an Expenditure on an intangible item should be recognized as an
expense on expense when it is incurred unless :
intangible asset
a) It forms part of the cost of an intangible asset that meets the
recognition criteria
b) The item is acquired in an amalgamation in the nature of
purchase and cannot be recognized as an intangible asset
If this is the case, this expenditure (included in the cost of
acquisition) should form part of the amount attributed to goodwill
(capital reserve) at the date of acquisition.
In some cases, expenditure is incurred to provide future economic
benefits to an enterprise, but no intangible asset or other asset is
acquired or created that can be recognized as an expense when it
is incurred. For example, expenditure on research is always
recognized as an expense when it is incurred. Examples of other
expenditure that its recognized as an expense when it is incurred
include :
a) Expenditure on start up activities (start up costs), unless this
expenditure is included in the cost of an item of fixed asset.
Start up costs may consist of preliminary expenses incurred in
establishing a legal entity
b) Expenditure on training activities
c) Expenditure on advertising and promotional activities; and
d) Expenditure on relocating on re-organizing part or all of an
enterprise.
7. Amortization on 1. Amortization period
intangible assets 2. Amortization method
3. Residual value
4. Review of amortization period and amortization method
8. Factors affecting The factors leading to goodwill are the following :
goodwill 1. Special locational advantages
2. Special commercial advantages such as a long term contract
for supply of raw materials at a low price or for sale of finished
goods at remunerative prices
3. Advantages because of prior entry specially if later is very
difficult
4. Advantages enjoyed by it because of certain patents available
to it
5. Technical know-how possessed by the firm
6. The research and development effort
9. Methods of valuing There are basically two methods of valuing goodwill :
goodwill i) Average profits method
ii) Super profits method
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

❖ PHASES OF GENERATION OF INTANGIBLE ASSETS

S. No. Heading Description

1. Meaning Identifiable non-monetary asset, without physical substance, held
for use in the production or supply of goods or services for rental to
others or for administrative purposes
2. Classification of Internally generated goodwill should not be recognized as an asset.
phases The generation of asset is classified into two phases :
a) Research phase : expenditure on research should not be
recognized as an intangible asset. These should be recognized
as an expenses when it is incurred.
b) Development phase : an intangible asset arising from
development phase should be recognized only if following
conditions are fulfilled.
- The technical feasibility of completing the intangible asset
so that it will be available for use or sale
- Its intention to complete the intangible asset and use or sell
it
- Its ability to use or sell the intangible asset
- The availability of adequate technical, financial and other
resources to complete the development and to use or sell
the intangible asset

❖ PURPOSES OF VALUATION OF SHARES

S. No. Heading Purposes of valuation of shares

1. Purpose of valuation of The valuation of shares may arise under the following
shares circumstances :

(a) Taxation Assessment under various direct tax laws

(b) Controlling interest Purchase of block of shares generally involving acquisition of

controlling interest in the company.

(c) Purchase by employees Purchase of shares by employees of the company

(d) Formulation of Formulation of schemes of amalgamation, absorption etc.

company

(e) Acquisition of interest Acquisition of interest of dissenting shareholder under a

scheme of reconstruction.

(f) Advancing loans Advancing loans on the security of shares

(g) Conversion Conversion of shares say preference into equity

(h) Deadlock resolution Resolving a deadlock in the management of a private limited

J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

company on the basis of the controlling block of shares being

given to either of the parties.

(i) Compensation from Compensating shareholders on the acquisition of their shares

Government by the government under a scheme of rationalization.

❖ FAIR VALUE OF SHARES

S. No. Heading Fair value of shares

1. Meaning - Fair value of the current price or value of an item. More

specifically, it is the amount that the item could be sold for
that is fair for both the buyer and the seller.
- Fair value does not relate to products being sold in
liquidation; rather it refers to products that are being sold
under normal, reasonable conditions
- Fair value becomes increasingly important when assets are
sold or a company is acquired.
2. Method of valuation

i) Net asset or intrinsic In this method value per share is arrived by dividing the net
value or net worth or asset of the company by number of equity shares. The
breakup value method calculation of net asset is done by adding all the asset at the
market value, net investments are included and if there is
preference share capital it should be deducted from it.

For example : land and building + plant and machinery +

furniture + stock + debtors + bill receivable + cash + goodwill –
debentures – current liabilities – preference share capital –
dividend arrears / number of equity shares.

ii) Yield or earning In this method the valuation of share is done by comparing
capacity valuation or expected rate of return with normal rate of return. If ERR > NRR
income method than market value of share is more than the paid up amount.
Otherwise market value of share is less than the paid up value.

iii) Fair value or dual This method is the combination of both the above methods.
method
Fair value of share = intrinsic value + yield value / 2

This method is also known as dual method of share valuation.

This method attempts to minimize the demerits of both the
methods.
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

❖ SUPER PROFIT METHOD OF VALUATION OF GOODWILL

S. No. Heading Description
1. Meaning Super profit is the excess of estimated future maintainable
profits over normal profits. An enterprise may possess some
advantages which enable it to earn extra profits over and
above the normal profit that would be earned if the capital of
the business was invested in some other business with similar
risks. The goodwill under this method is ascertained by
multiplying the super profits by certain number of year’s
purchase.
2. Information require Under this method of valuing goodwill would require the
following information :
- A normal rate of return for representative firms in the
industry
- The fair value of capital employed
- Estimated future maintainable profit
3. Calculation steps - Calculate capital employed (it is the aggregate of
shareholders’ equity and long term debt or fixed assets
and net current assets)
- Calculate normal profits by multiplying capital employed
with normal rate of return
- Calculate average maintainable profit
- Calculate super profit as follows :
Super profit = average maintainable profits – normal
profits
- Calculate goodwill by multiplying super profit by number
of year’s purchase
2017 – June [2] (c) Write a short note on valuation of shares bases on price earnings ratio.
(3 marks)
Answer :
S. No. Heading Description
1. Meaning This method is suitable for ascertaining the market value of
shares which are quoted on a recognized stock exchange
2. Calculation of price According to this method, the shares are valued on the
earnings ratio basis of earning per share multiplied by price earnings ratio.
Thus,
Market value of share =
Price earnings ratio x earning per share

Earning per share =

Profit available for equity shareholders
Number of equity shares
Price earnings ratio =
Market value per share
Earning per share
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

❖ INTERNALLY GENERATED INTANGIBLE ASSETS IN THE BOOKS OF ACCOUNT

S. No. Heading Description

1. Meaning - Internally generated assets like goodwill are recognized in

the books of accounts of the internally generated intangible
assets meets the criteria for recognition.
- An enterprise should distinguish the generation of the asset
into the research phase and the development phase. If the
enterprise cannot make such distinction, then expenditure
on that project should be considered to be in the research
phase only.
2. Classification of ➢ Research phase : intangible asset arising from research or
phases on the research phase of an internal project should be
recognized as an expenses when it is incurred.
➢ Development phase : an intangible assets arising from
development phase of an internal project should be
recognized only if, an enterprises can demonstrate of the
following conditions :
- The technical feasibility of completing the intangible
asset so that it will be available for use or sale
- Its intention to complete the intangible asset and use or
sell it
- Its ability to use or sell the intangible asset
- How the intangible asset will generate probable future
economic benefits. Among other things, the enterprise
should demonstrate the existence of a market for the
output of the intangible asset or the intangible asset
itself or, If it is to be used internally, the usefulness of
the intangible asset
- The availability of adequate technical, financial and
other resources to complete the development and to
use or sell the intangible asset; and
- Its ability to measure the expenditure attributable to
the intangible assets during its development reliably.
Internally generated brands, mastheads, publishing titles,
customer lists and items similar in substance should not be
recognized as intangible assets.
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

❖ AMORTIZATION PERIOD IN RELATION TO INTANGIBLE ASSETS

Heading Provision for Amortization on intangible assets

Amortization on - The depreciable amount of an intangible asset should

intangible assets be allocated on a systematic basis over the best
estimate of its useful life.
- There is a rebuttable presumption that the useful life of
an intangible asset will not exceed ten years from the
date when the asset is available for use.
- Amortization should commence when the asset is
available for use

- As the future economic benefits embodied in an

intangible asset are consumed over time, the carrying
amount of the asset is reduced to reflect that
consumption.
- This is achieved by systematic allocation of the cost of
the asset, less any residual value, as an expense over
the asset’s useful life. Amortization is recognized
whether or not there has been an increase in, for
example, the asset’s fair value or recoverable amount.
- Given the history of rapid changes in technology,
computer software and many other intangible assets
are susceptible to technological obsolescence
- Therefore, it is likely that their useful life will be short
- If control over the future economic benefits from an
intangible asset is achieved through legal rights that
have been granted for a finite period, the useful life of
the intangible asset should not exceed the period of the
legal rights unless the legal rights are renewable and
renewal is virtually certain.

- The amortization period should be reviewed at least at

each financial year end
Review of
- If the expected useful life of the asset is significantly
amortization period different from previous estimates, the amortization
and amortization period should be changed accordingly.
method

Retirement and An intangible asset should be derecognized or disposal or

disposal when no future economic benefits are expected from its
use and subsequent disposal.
 J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

❖ METHODS FOR VALUATION OF GOODWILL

✓ SUPER PROFIT METHOD

Goodwill Super Profit X No. of years of purchase

Super Profit Average Profit – Normal Profit

Normal Profit Average Capital Employed X NRR

Average Profit Note I

Average Capital Employed Note II
NRR Note III

Note I: Average Profit

For the purpose of Goodwill Valuation, problem provides past profits

If any adjustments are given year wise, then we should complete such adjustments
before calculating average profits

After completing the adjustments, we have to observe the trend to decide whether
to calculate Weighted Average or Simple Average

If the profits show rising trend, prefer weighted average. If the profits shows
declining trend or uneven trend, prefer Simple Average

If there is a loss in a particular year and the sum is silent regarding the same i.e. loss
is not justified or quantified, then ignore the loss making year.

Adjustments
a) Non Operating & Non Recurring Elements
Loss by fire, theft, any natural calamity
Profit on sale of fixed assets
Profit on sale of investments

b) Non Operating & Recurring Elements

Interest received on Non Trade Investments
Dividend received on Non Trade Investments
Rent received by letting out part of business premises
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

✓ Future Adjustments
After the above adjustments are over, we have to adjust the profits with respect
to future adjustments also:

a) Expenses incurred so far but not likely to be incurred in future

b) Expenses not incurred so far but likely to be incurred in future

c) Incomes received so far but not likely to be received in future

d) Incomes not received so far but likely to be received in future

✓ After completing all the adjustments with respect to past, present and future, the
profits so arrived are called as Future Maintainable Profits (FMP)

✓ So basically Average Profits are also known as Future Maintainable Profits (FMP)

Note II: Average Capital Employed

• Closing Capital Employed = Assets

• Assets should not include Goodwill, Non Trade Investments, Fictitious Assets
• Liabilities should only include external liabilities such as Secured Loans, Unsecured
Loans, Current Liabilities, Provisions
• Assets and Liabilities should be taken at revised values and if revised values are not
given in the question, then take book values
• Normally, Closing Capital Employed = Average Capital Employed
• But if in the Balance Sheet, proposed dividend is given, then ½ of profits should be
deducted while calculating average capital employed.

Note III: Normal Rate of Return (NRR)

• NRR is also called as expected rate of return, fair rate of return on capital invested,
standard return in similar business of similar industry
• NRR will always be given in the question

• If NRR is given with some risk factor, then NRR = Given % + % of Risk Factor
• NRR based on Dividend Basis (Dividend Yield Ratio)
NRR = DPS X 100
MPS

• NRR based on Yield Basis (Earnings Yield Ratio)

NRR = EPS X 100
MPS
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

✓ ANNUITY METHOD
Goodwill = Super Profit X Annuity Value

✓ CAPITALISATION OF SUPER PROFIT

Goodwill = Super Profit
NRR

✓ CAPITALISATION OF AVERAGE PROFITS (FMP)

Goodwill = Average Profit - Actual Capital Employed
NRR
 J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

❖ METHODS FOR VALUATION OF SHARES

✓ INTRINSIC VALUE METHOD

It is also known as
• Liquidation Method
• Balance Sheet Method
• Asset Backing Method
• Net Assets Method

Value Per Share Net assets for ESH

No. of Equity Shares

How to calculate Net Assets for Equity Shareholders (ESH)

Closing Capital Employed as per Goodwill XX

Add: Goodwill XX

Add: Non Trade Investments XX

Less: Preference Share Capital (XX)

Net Assets for Equity Shareholders (ESH) XX

If in the question, Premium on Redemption is given or Proposed Preference Dividend is given or

arrears of Preference Dividend is given, then the same should also be deducted while calculating
Net Assets for Equity Shareholders (ESH).

✓ YIELD VALUE METHOD

It is also known as
• Profitability Method
• Going Concern Method
• Productivity Method

Value Per Share ARR X Paid up value or Face value

NRR
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

How to calculate Average Rate of Return (ARR)

ARR Average Profits for ESH X 100

Paid up Equity Share Capital

Average Profits for Equity Shareholders (ESH)

Average Profits as per Goodwill XX

Less: Transfer to reserves (XX)

Less: Preference Dividend (XX)

Average Profits for Equity Shareholders (ESH) XX

✓ FAIR VALUE METHOD

Value Per Share Intrinsic value per share + Yield value per share
2
J. K. SHAH CLASSES CS EXECUTIVE – MANAGEMENT ACCOUNTING

PART B: PRACTICAL
VALUATION OF GOODWILL
Q.1.The net profit of a business after providing for taxation, for the past five years are: ` 40,000, `
42,500, ` 46,000, ` 52,500 and ` 59,000. The capital employed in the business is ` 4,00,000. The
normal rate of return expected in this type of business is 10%. It is expected that the company will
be able to maintain its-super profit for the next 5 years.
Calculate the value of goodwill on the basis of:
(i) Five years' purchase of super profits;
(ii) Annuity method, taking the present value of annuity of Re. 1 for five years at 10% as 3.78;
and
(iii) Capitalisation of super profits.

VALUATION OF SHARES

Q.2. Balance Sheet of Diamond Ltd. on 30th June, 2020

Liabilities `
Share capital:
2,000 shares of Rs.100 each 2,00,000
General reserve 40,000
Profit and loss account 32,000
Sundry creditors 1,28,000
Income Tax provision 60,000
4,60,000
Assets `
Land and Buildings 1,10,000
Plant and machinery 1,30,000
Patents and trade marks 20,000
Stock 48,000
Debtors 88,000
Bank balance 52,000
Preliminary expenses 12,000
4,60,000
The expert valuer valued the land and buildings at ` 2,40,000, goodwill at ` 1,60,000 and Plant and
Machinery at ` 1,20,000. Out of the total debtors, it is found that debtors of `8,000 are bad. The
profits of the company have been as follows:
Years `
2016 80,000
2017 90,000
2018 1,06,000

The company follows the practice of transferring 25% of profits to general reserve. Similar type of
companies earn at 10% of the value of their shares.
Ascertain the value of shares of the company under:
(i) Intrinsic value method.
(ii) Yield value method; and
(iii) Fair value method.
Ignore taxation. Note: Assume that depreciation is charged on land & Building at 10% & plant at
15%.