The method of share valuation by the method of yield is a popular way to determine the worth of the company’s shares by means of the returns that the investors can have. For instance, it takes the dividend or earnings per share and divides it by the share price to calculate return. This method is mainly used by investors and financial analysts to find out if stocks are of a low or high valuation level.
Valuation of stock is important for financial institutions, companies, and investors. Valuation assists in decision-making in mergers and acquisitions, investment decisions, and company restructuring. The yield approach of valuation takes into account the prospective returns and, therefore, serves as a primary method for share evaluation.
This article is going to tell us what valuation of shares is, the method of valuation of shares through yield, its composition, and illustrations. We shall also be describing the earning yield method and the dividend yield method, which are the two key forms of valuation based on yield.
What is Valuation of Shares?
Share valuation is the determination of the value of a company’s stock. Share valuation assists investors in knowing if the share price is reasonable, overvalued, or undervalued. Various methods of calculation of the share price are used by firms, investors, and analysts.
Why is Share Valuation Important?
- Enables investors to make better decisions.
- Helps companies raise funds, make acquisitions, and merge.
- Guarantees equitable pricing at the time of issuance of new shares.
- Assists in taxation and financial reporting.
There are various ways of valuing shares, such as the net asset method, market price method, and yield method of share valuation. Out of these, the yield method is important as it takes into account the return on investment that can be obtained.
What is Yield Method of Valuation of Shares?
The yield approach to valuing shares is a straightforward method. It helps determine how much a stock is worth by looking at the returns it should give you. Stocks can show these returns in two ways: through an earnings yield or a dividend yield. Earnings yield tells you how much profit a company makes compared to its stock price. Dividend yield tells you the percentage of the stock price that the company pays to its shareholders in dividends. Both these yields help investors understand the potential returns from a stock.
Key Features of Yield Method
- Considers profitability and company performance.
- Emphasizes anticipated returns to shareholders.
- Aids to compare various investment opportunities.
This strategy is great for investors looking for a stable income through dividends. It also benefits those aiming for earnings growth. Let’s dive deeper into understanding this approach.
Breakdown of the Yield Method
The yield method generally follows two approaches:
- Earning Yield Method – From profits.
- Dividend Yield Method – Dividend based.
These methods provide different perspectives on valuing shares. The earning yield method focuses on the total earnings a company makes. In contrast, the dividend yield method emphasizes the cash payouts given to shareholders.
Earning Yield Method
The earning yield approach measures the return on investment in terms of the firm’s earnings. It assists investors in ascertaining how much profit a firm is making in relation to its share price.
Formula:
How It Works:
- Locate the earnings per share (EPS) from the firm’s financial records.
- Find the current market price of the share.
- Use the formula to obtain the percentage yield.
Example:
If a company’s EPS is ₹20 and its market price is ₹200:
This means the company generates a 10% return on its share price.
Dividend Yield Method
The dividend yield approach is a basic method that investors who have a focus on stable cash flow from their investments with regular dividends will use. This approach calculates the return via dividends per share based against the share price, which is perfect for dividend-seeking investors. Shares of companies with regular and increasing dividends are generally considered low-risk borrowers, and even a moderate dividend rate is sufficient to entice conservative investors. While the earning yield method looks at general taking a profit of the entire firm, the dividend yield method measures the cash return because ‘you’ as an investor will receive. This is an important concept to understand for anyone who wants to build a reliable income stream from investments.
Formula:
How It Works:
- Set a token and wage dividens every time share is used to make a transaction.
- Locate the share currently applicable rate in the market.
- Utilize the formula D/Y to find out the dividend yield during a certain period.
Example:
If a company pays a dividend of ₹5 per share and its market price is ₹100:
This means investors earn 5% return in the form of dividends.
Yield Method of Valuation of Shares Example
Let’s apply both methods to an example:
| Factor | Value |
| Earnings per Share (EPS) | ₹30 |
| Dividend per Share | ₹10 |
| Market Price per Share | ₹300 |
Earning Yield Calculation:
(30/300)×100=10%
Dividend Yield Calculation:
(10/300)×100=3.33%
This implies that the company provides a 10% return on earnings and 3.33% on dividends. Investors can choose which factor is more significant depending on their objectives.
Relevance to ACCA Syllabus
The yield approach of share valuation is a critical area in ACCA syllabus papers of Financial Management (FM) and Advanced Financial Management (AFM). The concept enables the students to appreciate valuation methods that aid investment, financial analysis, and corporate finance policies. The students are required to use the concept to establish the fair value of shares in investment, merger, and acquisitions.
Yield Method of Valuation of Shares ACCA Questions
Q1: What is the primary purpose of using the yield method for share valuation?
A) To determine the net asset value of the company
B) To estimate the share value based on expected returns
C) To calculate historical share prices
D) To measure the book value of equity
Ans: B) To estimate the share value based on expected returns
Q2: The earning yield method measures share valuation based on which financial metric?
A) Dividend payout ratio
B) Net income divided by market price per share
C) Market capitalization divided by total assets
D) Total debt divided by total equity
Ans: B) Net income divided by market price per share
Q3: Which of the following statements is true about the dividend yield method?
A) It values a company based on its net profit
B) It calculates share valuation based on dividends paid to shareholders
C) It considers capital gains and market trends
D) It is irrelevant for companies that do not pay dividends
Ans: B) It calculates share valuation based on dividends paid to shareholders
Q4: A stock with a high dividend yield is likely to be:
A) A high-growth stock with no dividend payments
B) A mature company with stable income distribution
C) A newly listed company with volatile earnings
D) A company with a low return on assets
Ans: B) A mature company with stable income distribution
Relevance to US CMA Syllabus
The Certified Management Accountant (CMA) course syllabus includes company share valuation methods as well, in Part 2 – Financial Decision Making. The knowledge that US CMA candidates must apply when it comes to evaluating whether an investment makes sense and the associated risks.
Yield Method of Valuation of Shares US CMA Questions
Q1: In the yield method of valuation, which ratio is most commonly used to compare investment returns?
A) Price-to-earnings ratio
B) Earnings yield
C) Net profit margin
D) Return on equity
Ans: B) Earnings yield
Q2: The dividend yield method is primarily used by investors who prioritize:
A) Capital appreciation
B) Regular income from dividends
C) Buying and selling shares in the short term
D) Market speculation
Ans: B) Regular income from dividends
Q3: A company has a dividend per share of $4 and a market price of $80. What is its dividend yield?
A) 5%
B) 6%
C) 4%
D) 3%
Ans: A) 5%
Q4: Why is the earnings yield method preferred by investors over the dividend yield method in some cases?
A) It considers the company’s reinvested profits
B) It ignores market fluctuations
C) It calculates only historical performance
D) It is the only method used for share valuation
Ans: A) It considers the company’s reinvested profits
Relevance to US CPA Syllabus
In the Certified Public Accountant (CPA) exam, more so in the Financial Accounting and Reporting (FAR) and Business Environment and Concepts (BEC) section, knowing the yield method of share valuation is important to accountants. It is employed in the valuation of equity securities as well as in investment returns that assist in planning finances, taxation, and advisory functions.
Yield Method of Valuation of Shares US CPA Questions
Q1: The yield method of share valuation is most relevant for which type of financial reporting?
A) Cash flow statements
B) Valuation of securities and investments
C) Cost allocation in managerial accounting
D) Statement of retained earnings
Ans: B) Valuation of securities and investments
Q2: The earnings yield of a stock is calculated as:
A) Earnings per share divided by the book value of assets
B) Earnings per share divided by market price per share
C) Market price per share divided by net income
D) Total revenue divided by total shares outstanding
Ans: B) Earnings per share divided by market price per share
Q3: A company’s earnings yield is 12%. What does this imply?
A) The company generates 12% returns relative to its share price
B) The company pays 12% of its earnings as dividends
C) The company’s share price will increase by 12%
D) The company has a return on assets of 12%
Ans: A) The company generates 12% returns relative to its share price
Q4: Which of the following statements best describes the use of the yield method in accounting?
A) It calculates asset depreciation
B) It helps in valuing equity instruments for financial reporting
C) It determines tax liability for companies
D) It focuses only on future dividends
Ans: B) It helps in valuing equity instruments for financial reporting
Relevance to CFA Syllabus
For CFA candidates, share valuation is an essential part of Level I, II, and III exams under Equity Investments. The yield method of share valuation enables CFA students to evaluate financial markets, estimate risk-adjusted returns, and provide data-based investment suggestions.
Yield Method of Valuation of Shares CFA Questions
Q1: The yield method of share valuation is primarily used in:
A) Corporate debt analysis
B) Equity valuation and investment decision-making
C) Fixed income security pricing
D) Real estate valuation
Ans: B) Equity valuation and investment decision-making
Q2: If a company’s dividend yield increases, what could be a possible reason?
A) Its stock price has risen
B) Its dividend payment has decreased
C) Its stock price has fallen or its dividend payout has increased
D) The company has issued more shares
Ans: C) Its stock price has fallen or its dividend payout has increased
Q3: What does a high earnings yield generally indicate about a stock?
A) It is potentially undervalued
B) It has strong dividend payout policies
C) It is always a high-risk investment
D) It has weak earnings growth
Ans: A) It is potentially undervalued
Q4: The dividend discount model (DDM) is closely related to which yield valuation method?
A) Earnings yield method
B) Dividend yield method
C) Market capitalization model
D) Price-to-earnings method
Ans: B) Dividend yield method
