Yield Method of Valuation of Shares

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