by 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
One thought on “Yield Method of Valuation of Shares”