Large businesses and business intending to be large are organized as companies for they provide the triple advantage of
- ‘Existence at will’ for they survive till their shareholders decide to dissolve them
- Limited liability enabling many unrelated investors to collaborate, and
- Transferable shares, providing liquidity to their shareholders without impairing the liquidity of the Company
A key ingredient that ensured the growing success of companies is the evolution in valuation of shares that permitted shareholders to sell and investors to buy shares without diluting any of the economic advantages of ownership.
The evolution of share valuation is episodic, marked by stock market bubbles and often a major scandal that highlighted the limitation of the valuation method used which burst the bubble. The first of the four methods is the Dividend Capitalization method that evolved in the 18th century, followed by the Book Value method of the 19th century and the Price Earning Ratio of the 20th century. The 21st century saw the advent of dotcom/internet companies with long gestation periods that gave rise to the technique of valuing even loss-making entities with potential.
This is the second article in this series that captures the concept, the trigger and the limitations of the book value method. In the next two articles, the concept, trigger and limitations of the other two valuation methods that followed the book value method will be described.
Equity shares represent ownership in the company and hence the value of all the equity shares issued by the company in equal to the value of all assets owned by the company less the liabilities owed by the company. Given this understanding, the value of a single equity share is equal to the net worth of the company divided by the number of equity shares. In cases where the company has issued preference shares, the net worth of the company should be reduced by the value of the preference shares issued to get the net worth that belongs to all the equity shareholders. Using this principle, the value of one equity shares is arrived at by dividing the net worth that belongs to all the equity shareholders by the number of equity shares outstanding.
The First of First
The advent of railways in 1840s was seen as a major technological revolution that would accelerate the pace of economic growth thereby ushering in a new era of prosperity. For the first time railway companies were actively traded in the US and London stock market with their share prices going up sharply. The fact that railway companies had a gestation period of few years before they generate revenue and profits posed a challenge to the investors who could not value its shares based on dividend capitalization method.
Some investors saw the equity shares of railway companies as a secured debt instrument, backed by the security of net assets owned by the company after its liability was paid-off. These investors compared the price at which equity shares of the railway companies traded with the book value per share of the company to conclude:
- if the share price was equal to the book value per share, the share is fairly valued,
- If the share price was less than the book value per share, the share was undervalued and a signal to buy, and
- If the share price was higher than the book value per share, the share was overvalued and a signal to sell.
As the book value method of valuation gained acceptance, a few promoters of railway companies misused it by having their company buy assets at inflated prices and diverting the padded price of assets to their own pocket Investor who blindly went by book value method to buy shares in these companies lost their money as the inflated assets did not deliver profits in line with their investment, thereby exposing its fallacy.
The deceitful methods used by promoters to inflate asset value had its inspiration in a similar practice followed in cattle trade in the US called the watered stock. In this scheme, rangers going to market to sell would feed their cattle with salt the previous day and deprive it of water. In the morning before going to market where the cattle were valued for their weight, the rangers would let the cattle drink water thereby increasing their weight and benefit from it at the buyers’ cost.
For companies that do not have a dividend payment track record, book value valuation is a good method, however it could be misused by unscrupulous promoters like in cattle trade by watering their stocks. Hence while using book value method, there is a need to supplement it with external validation of the asset values to arrive at fair value.