Determination of Normal Rate of Return and Capitalisation Factor :

This obviously has a tremendous bearing on the ultimate result, but unfortunately it is subjective and, therefore, valuers differ more widely in this area than any other in the whole valuation process. As a general rule, the nature of investment would decide the rate of return. Companies, investment in which is more risky would call for a larger rate of return, and, consequently they will have a lower capitalisation factor and lower valuation than companies with assured profits. For investments in Government securities, the risk is least and, consequently, an investor would be satisfied with a very low rate of return. In a logical order, we find mortgage debentures, being riskier than government paper, require slightly higher rate of return. Preference shares are less risky than equity shares but more risky than mortgage debentures; preference shares rank in between debentures and equity shares in the matter of return. Equity shares are exposed to highest risks and, consequently, the normal rate of return is highest in case of equity shares, though equity shares of progressive and soundly managed companies, provide a safeguard against inflation – equity share prices are likely to rise sufficiently high to counteract the effect of a rise in prices.

The above also applies to companies and industries and the normal rate of return will always depend on the attendant risk. In this respect, net tangible asset backing is relevant. The higher net tangible asset backing for each share, greater would be the confidence of the investor. Normally, 2 to 3 times backing is consider satisfactory.

This ratio should be reviewed carefully to ascertain whether shares are inadequately covered or too much covered which may indicate over capitalisation in the form of idle funds or inadequate use of productive resources. Symptoms suggesting idle assets would be holding of large cash and bank balances, high current ratio, unutilised land, plant and machinery, etc. The normal rate of return should be increased suitably in either case. Further, if any disabilities attach to the concerned share such as the share being partly paid, the normal rate of return would be higher.

If the concerned company has special features, the normal rate of return will have to be suitably modified. Thus, the following additional factors are to be considered:

(i) Restrictions on transfer of shares – The normal rate of return will be increased say, by ½%.

(ii) Disabilities attached to shares will also cause the normal rate of return to go up e.g. if shares are partly paid-up, the investors will expect a higher yield (say by ½% higher) than in case of fully paid shares.

(iii) Dividend performance – stability in dividend will decrease the normal rate.

(iv) Financial prudence on the part of the company’s management also affects the normal rate of return. A company which distributes only a part of the profit will attract investors without offering high yield.

(v) Net asset backing is important from the point of view of safety. The poor net asset backing will increasethe normal rate since the investors consider themselves unsafe.