Tag: Consolidated Financial Statements

Yield Method, also known as the Earnings Method, Profit-Earning Capacity Method, or Capitalisation Method, is a method of valuation of shares based on the earning capacity of a company. Under this method, the value of shares is determined by comparing the company’s expected earnings or dividends with the normal rate of return prevailing in the industry. The basic assumption is that the value of a share depends on the income it can generate for investors.

Unlike the Net Asset Method, which focuses on asset backing, the Yield Method emphasizes profitability and future income, making it more suitable for valuing shares of a going concern.

Concept and Rationale of Yield Method

The Yield Method is based on the principle that investors invest in shares to earn returns, either in the form of dividends or capital appreciation. A rational investor compares the return offered by a company with the return available from alternative investments carrying similar risk. If a company offers a higher yield than the normal rate, its shares are valued higher, and vice versa.

This method assumes that:

• Past profits are a reliable indicator of future profits

• Profits are stable or reasonably predictable

• The business will continue operations for the foreseeable future

Hence, the Yield Method measures the true earning power of a company.

Applicability of Yield Method

The Yield Method is particularly suitable in the following cases:

• Valuation of shares of profitable and going concerns

• Companies with stable and regular earnings

• Valuation for mergers, acquisitions, and takeovers

• Determination of share exchange ratio

• Valuation of unquoted equity shares

• Settlement of disputes among shareholders

It is less suitable where profits fluctuate widely or where assets play a dominant role.

Types of Yield Method

The Yield Method can be classified into two main types:

• Earnings Yield Method

• Dividend Yield Method

Both methods are explained in detail below.

1. Earnings Yield Method

Under the Earnings Yield Method, shares are valued based on the earning capacity of the company. The maintainable profits are capitalized at the normal rate of return to determine the value of shares. This method considers profits available to equity shareholders, irrespective of the dividend actually distributed.

Steps Involved in Earnings Yield Method

Step 1. Calculate maintainable profits by adjusting past profits for abnormal items.

Step 2. Deduct preference dividend and taxes, if required.

Step 3. Determine earnings available to equity shareholders.

Step 4. Calculate Earnings Per Share (EPS).

Step 5. Capitalize EPS at the normal rate of return.

Formula

Value per Equity Share = (Earnings per Share × 100) / Normal Rate of Return

Where,

Earnings per Share (EPS) = Profit available to equity shareholders / Number of equity shares

Illustrative Explanation

If a company earns ₹2,00,000 as maintainable profit, has 20,000 equity shares, and the normal rate of return is 10%:

EPS = 2,00,000 / 20,000 = ₹10
Value per share = (10 × 100) / 10 = ₹100

Merits of Earnings Yield Method

• Focuses on earning capacity

• Suitable for profitable companies

• Reflects investor expectations

• Simple and widely accepted

• Ideal for going concerns

Limitations of Earnings Yield Method

• Ignores asset backing

• Depends on estimation of maintainable profits

• Sensitive to changes in normal rate of return

• Not suitable for companies with fluctuating profits

2. Dividend Yield Method

Dividend Yield Method is a variation of the yield method where shares are valued based on the dividend-paying capacity rather than earnings. This method assumes that dividends are the primary source of return for investors. It is especially relevant where dividends are regular and stable.

Steps Involved in Dividend Yield Method

Step 1. Ascertain the expected dividend on equity shares.

Step 2. Calculate Dividend per Share (DPS).

Step 3. Capitalize DPS at the normal rate of return.

Formula

Value per Equity Share = (Dividend per Share × 100) / Normal Rate of Return

Where,
Dividend per Share (DPS) = Total equity dividend / Number of equity shares

Illustrative Explanation

If a company pays a dividend of ₹8 per share and the normal rate of return is 10%:

Value per share = (8 × 100) / 10 = ₹80

Merits of Dividend Yield Method

• Simple and practical

• Useful where dividends are stable

• Reflects actual cash return to shareholders

• Suitable for income-oriented investors

Limitations of Dividend Yield Method

• Ignores retained earnings

• Not suitable for growth companies

• Dividend policy may distort valuation

• May undervalue companies with high retention

Valuation of equity shares is the process of determining the fair or intrinsic value of shares based on the financial position, profitability, and future prospects of a company. Equity shares represent ownership in the company and may be fully paid-up or partly paid-up depending on the amount of share capital paid by shareholders. The valuation of these two types of shares differs mainly due to the existence of future payment liability in partly paid-up shares.

1. Fully Paid-Up Equity Shares

Fully paid-up equity shares are those shares on which the entire face value has been paid by the shareholders. There is no outstanding amount payable on these shares. Holders of fully paid-up shares enjoy full ownership rights, including voting rights, dividend entitlement, and transferability. Since there is no further financial obligation, the valuation of fully paid-up equity shares is simpler and more reliable.

Need for Valuation of Fully Paid-Up Equity Shares

The valuation of fully paid-up equity shares becomes necessary in several situations such as:

• Amalgamation and merger of companies

• Acquisition or takeover

• Issue of bonus shares

• Conversion of debentures into equity shares

• Transfer of shares in private companies

• Settlement of disputes among shareholders

In such cases, market price may not reflect true value, especially when shares are unquoted.

Methods of Valuation of Fully Paid-Up Equity Shares

Fully paid-up equity shares are valued using standard valuation methods:

• Net Asset Value Method

Under this method, the value of equity shares is based on the net assets available to equity shareholders.

Formula:

Value per fully paid-up equity share = Net assets available to equity shareholders / Number of equity shares

This method is suitable during liquidation or when asset strength is important.

• Yield or Earnings Method

This method values shares based on the earning capacity of the company.

Formula:

Value per fully paid-up equity share = (Earnings per share × 100) / Normal rate of return

It is suitable for going concerns and profitable companies.

• Fair Value Method

This method takes the average of values obtained under the Net Asset Method and Yield Method.

Formula:

Fair value per share = (Net asset value per share + Yield value per share) / 2

It is widely used because it considers both assets and profitability.

2. Valuation of Partly Paid-Up Equity Shares

Partly paid-up equity shares are those shares on which only a part of the face value has been paid, and the remaining amount is yet to be called by the company. Shareholders holding partly paid-up shares have a future liability to pay the unpaid amount when calls are made. Due to this additional risk and obligation, partly paid-up shares are valued lower than fully paid-up shares.

Reasons for Lower Valuation of Partly Paid-Up Shares

The valuation of partly paid-up equity shares is lower due to the following reasons:

• Existence of future payment obligation

• Higher risk to shareholders

• Limited transferability in some cases

• Dividend entitlement only on paid-up capital

• Possibility of forfeiture if calls are not paid

These factors reduce the attractiveness and value of partly paid-up shares.

Method of Valuation of Partly Paid-Up Equity Shares

The valuation of partly paid-up equity shares is generally derived from the value of fully paid-up equity shares.

• Proportionate Value Method

Under this method, the value of a partly paid-up share is calculated in proportion to the amount paid.

Formula:

Value of partly paid-up share = Value of fully paid-up share × (Paid-up value / Face value)

• Deduction Method

Alternatively, the unpaid amount is deducted from the value of a fully paid-up share.

Formula:

Value of partly paid-up share = Value of fully paid-up share – Unpaid amount per share

This method ensures that the shareholder’s future liability is fully adjusted.

Illustration of Valuation

Suppose the value of a fully paid-up equity share of ₹100 is ₹150. If ₹60 is paid and ₹40 is unpaid:

Using proportionate method:
Value = 150 × (60/100) = ₹90

Using deduction method:
Value = 150 – 40 = ₹110

In practice, the deduction method is commonly preferred as it fully accounts for the unpaid liability.

Valuation of shares refers to the process of determining the intrinsic or fair value of a company’s shares. Since market prices may not always reflect the true worth of shares, especially in the case of unquoted companies, different valuation methods are adopted depending on the purpose of valuation and nature of the business.

The important methods of valuation of shares are explained below:

1. Net Asset Value Method (Asset Backing Method)

Under this method, shares are valued based on the net assets of the company available for shareholders. All assets are valued at their realizable or fair values and liabilities are deducted to arrive at net assets. The net assets are then divided by the number of equity shares.

Formula:

Value per Equity Share = Net Assets available to Equity Shareholders / Number of Equity Shares

This method is suitable when the company is being wound up or where assets play a major role. However, it ignores earning capacity.

2. Yield Method (Earnings / Profit-Earning Capacity Method)

The Yield Method values shares based on the earning capacity of the company. It compares the company’s earnings with the normal rate of return prevailing in the industry. Expected maintainable profits are capitalized to determine share value.

Formula:

Value per Share = (Earnings per Share × 100) / Normal Rate of Return

This method is suitable for going concerns and emphasizes profitability rather than assets.

3. Dividend Yield Method

This method is a variation of the yield method and is based on the dividend-paying capacity of the company. The value of a share is determined by capitalizing the expected dividend at the normal rate of return.

Formula:

Value per Share = (Dividend per Share × 100) / Normal Rate of Return

This method is appropriate when dividends are stable and regular. However, it ignores retained earnings and growth potential.

4. Fair Value Method

The Fair Value Method combines both asset-based and earning-based approaches. The value of shares is calculated as the average of the values obtained under the Net Asset Value Method and Yield Method.

Formula:

Fair Value per Share = (Net Asset Value per Share + Yield Value per Share) / 2

This method is widely accepted as it considers both financial strength and earning capacity.

5. Market Price Method

Under this method, the stock exchange quoted price of shares is taken as the value. Generally, the average of the market price over a reasonable period is considered.

This method is applicable only when shares are actively traded on a recognized stock exchange. It reflects investor perception but may be influenced by speculation and market fluctuations.

6. Capitalisation Method

In the Capitalisation Method, the value of the entire business is determined by capitalizing its expected profits at the normal rate of return. The total value is then divided by the number of shares to arrive at the value per share.

Formula:

Capitalised Value = Expected Profit × 100 / Normal Rate of Return

Value per Share = Capitalised Value / Number of Shares

This method is suitable for stable businesses with predictable earnings.

7. Intrinsic Value Method

The Intrinsic Value Method focuses on the true worth of a share based on financial statements, assets, liabilities, and earning potential. It is commonly used by investors for long-term investment decisions.

This method requires careful analysis and judgment, making it more complex but reliable.

Goodwill represents the ability of a business to earn profits in excess of the normal return on capital employed. Since goodwill is an intangible asset, its valuation requires the application of appropriate methods based on profits, capital, or super profits. The commonly used methods of valuation of goodwill are discussed below.

1. Average Profit Method

Under the Average Profit Method, goodwill is valued on the basis of the average maintainable profits of the business. Past profits of a certain number of years are adjusted for abnormal items and averaged. Goodwill is then calculated by multiplying the average profit by an agreed number of years’ purchase.

Formula:

Goodwill = Average Profit × Number of Years’ Purchase

This method is simple and widely used when profits are stable. However, it ignores the normal rate of return and capital employed, making it less suitable where profits fluctuate significantly.

2. Weighted Average Profit Method

The Weighted Average Profit Method is an improvement over the simple average profit method. Here, greater weight is assigned to recent profits on the assumption that recent performance better reflects future earning capacity. Profits of past years are multiplied by predetermined weights, and the weighted average profit is calculated.

Formula:

Weighted Average Profit = Total of (Profit × Weight) / Total Weights

Goodwill = Weighted Average Profit × Number of Years’ Purchase

This method is useful when profits show a rising or declining trend, but it still does not consider capital investment.

3. Super Profit Method

Under the Super Profit Method, goodwill is valued based on excess profits earned over normal profits. Normal profit is calculated by applying the normal rate of return to the capital employed. The difference between average maintainable profit and normal profit is known as super profit.

Formula:

Super Profit = Average Maintainable Profit – Normal Profit

Goodwill = Super Profit × Number of Years’ Purchase

This method is logical and widely accepted because goodwill arises only when a firm earns above-normal profits.

4. Annuity Method of Super Profits

The Annuity Method is a refined version of the super profit method. It considers the time value of money by discounting future super profits. The present value of super profits for a specified number of years is calculated using annuity tables.

Formula:

Goodwill = Super Profit × Present Value of Annuity Factor

This method is more scientific and realistic, especially when super profits are expected to continue for a limited period. However, it is complex and requires accurate estimation of discount rates.

5. Capitalisation of Average Profits Method

Under this method, goodwill is calculated by capitalising the average profits at the normal rate of return. The capitalised value of the business is compared with the actual capital employed.

Formula:

Capitalised Value = Average Profit × 100 / Normal Rate of Return

Goodwill = Capitalised Value – Capital Employed

This method is suitable when profits are stable and the normal rate of return is known. It reflects the total value of the business but depends heavily on accurate estimation of the normal rate.

6. Capitalisation of Super Profits Method

In this method, goodwill is valued by capitalising the super profits instead of average profits. Super profits are divided by the normal rate of return to arrive at the value of goodwill.

Formula:

Goodwill = Super Profit × 100 / Normal Rate of Return

This method directly links goodwill with excess earning capacity. It is simple and widely used in practice, especially during partnership changes and business acquisitions.

7. Purchase of Past Profits Method

Under the Purchase of Past Profits Method, goodwill is calculated as a multiple of past profits without adjusting for future expectations or normal return. The number of years’ purchase is determined through negotiation.

Formula:

Goodwill = Past Profits × Agreed Number of Years’ Purchase

This method is easy to apply but is considered less reliable as it does not consider future profitability, capital employed, or industry conditions.

8. Market Value Method

The Market Value Method values goodwill based on the difference between the market value of shares and the book value of net assets. It is mainly used for joint-stock companies whose shares are quoted on the stock exchange.

Formula:

Goodwill = Market Value of Company – Net Assets at Fair Value

This method reflects investor perception and market confidence but is influenced by stock market fluctuations and speculation.

9. Global Valuation Method

Under the Global Valuation Method, the entire business is valued as a whole based on expected future earnings, market conditions, and risk. From this total valuation, the fair value of net tangible assets is deducted to arrive at goodwill.

Formula:

Goodwill = Total Business Value – Net Tangible Assets

This method is suitable for mergers and acquisitions but requires expert valuation and professional judgment.

Accounting standards prescribe specific rules for the recognition, measurement, treatment, and impairment of goodwill to ensure uniformity and transparency in financial reporting. The major provisions relating to goodwill under different accounting standards are explained below.

1. AS 14 – Accounting for Amalgamations (Indian GAAP)

AS 14 governs the treatment of goodwill arising from amalgamations. Goodwill arises only when the amalgamation is in the nature of purchase and the purchase consideration exceeds the net value of assets acquired. Such goodwill is recorded as an asset in the balance sheet. AS 14 recommends that goodwill should be amortised over a reasonable period, normally not exceeding five years, unless a longer period is justified. If the purchase consideration is less than net assets, the difference is treated as capital reserve, not goodwill.

2. AS 26 – Intangible Assets

AS 26 deals with accounting for intangible assets, including goodwill. It clearly states that internally generated goodwill is not recognised because its cost cannot be measured reliably. Only purchased goodwill can be recognised as an asset. AS 26 requires goodwill to be amortised systematically over its useful life. If the useful life cannot be estimated reliably, it should not exceed ten years. The standard also emphasizes periodic review to assess impairment, ensuring that goodwill is not overstated.

3. AS 10 (Revised) – Property, Plant and Equipment

AS 10 (Revised) does not directly prescribe accounting treatment for goodwill but provides important clarification. It states that goodwill is not a tangible asset and therefore cannot be classified as property, plant, or equipment. Any expenditure that leads to internally generated goodwill cannot be capitalised. This reinforces the principle that goodwill is an intangible asset, governed by AS 26 or AS 14. The standard indirectly supports conservative accounting by preventing improper capitalization of goodwill-related expenditure.

4. Ind AS 103 – Business Combinations

Ind AS 103 provides comprehensive guidance on goodwill arising from business combinations. Goodwill is recognised as the excess of consideration transferred over the fair value of identifiable net assets acquired. Unlike AS 14, Ind AS 103 prohibits amortisation of goodwill. Instead, goodwill is subject to annual impairment testing. If the consideration is less than net assets, it results in a bargain purchase gain, which is recognised in profit or loss after reassessment, ensuring fair value-based accounting.

5. Ind AS 36 – Impairment of Assets

Ind AS 36 specifically governs the impairment testing of goodwill. Goodwill acquired in a business combination must be allocated to one or more cash-generating units (CGUs). The standard requires goodwill to be tested for impairment at least annually, irrespective of whether there is any indication of impairment. If the carrying amount exceeds the recoverable amount, an impairment loss is recognised in profit or loss. Importantly, impairment losses on goodwill cannot be reversed, ensuring prudence.

6. IAS 38 – Intangible Assets (International Standard)

IAS 38 lays down international principles for accounting for intangible assets, including goodwill. It strictly prohibits recognition of internally generated goodwill due to measurement uncertainty. Purchased goodwill is recognised only when it arises from a business combination under IFRS. IAS 38 clarifies that goodwill cannot be separated or sold independently and therefore does not permit subsequent revaluation. This standard ensures that goodwill reflects future economic benefits without overstating asset values.

7. IFRS 3 – Business Combinations

IFRS 3 governs the recognition and measurement of goodwill at the international level. It defines goodwill as the future economic benefits arising from assets that are not individually identifiable. IFRS 3 disallows amortisation of goodwill, adopting an impairment-only model. Goodwill is tested annually for impairment under IAS 36. Any bargain purchase is recognised immediately as income in profit or loss. These provisions promote transparency and fair valuation in global financial reporting.

8. Comparative and Conceptual Overview

Traditional Indian Accounting Standards (AS) permit amortisation of goodwill, while Ind AS and IFRS prohibit amortisation and require impairment testing. All standards uniformly disallow recognition of internally generated goodwill. The shift from amortisation to impairment reflects a move toward fair value and economic substance over conservative cost-based accounting. This evolution improves the relevance of financial statements by ensuring goodwill represents real future benefits rather than arbitrary write-offs.