Valuation Based on Productivity Factor

Productivity factor is a concept of relative earning power. It represents the earning power in relation to the value of assets employed for such earnings. This gives a ratio which is applied to the net worth of the business as on the valuation date to arrive at the projected earning figure for the company. This projected earning after necessary adjustments (discussed later) shall be multiplied by the appropriate capitalisation factor to arrive at the value of the company’s business. The total value is divided by the number of equity shares to ascertain the value of each share.

The productivity factor based valuation is really a method for arriving at a reliable figure of future profits. The steps are the following:

(i) Take a number of years whose results are relevant to the future. Determine net worth of the business at the commencement and close of each of the accounting years under consideration and find out the average net worth for each year by adding the opening and closing net worth and dividing the result by 2; and, in turn, arriving at the average net worth of the business during the period under study.

(ii) Determine the net worth of the business on the valuation date.

(iii) Ascertain the average, weighted, if necessary, adjusted profit earned during the years under consideration.

(iv) Find out the percentage that (iii) bears to (i); that represents the productivity factor i.e.

= Average (weighted) profit x 100
     Average (weighted) networth

(v) Apply the productivity factor as obtained in (iv) above to the net worth on the valuation date to find out the projected income in future.

(vi) Adjust the projected taxed income for factors like appropriations for provision for replacement and rehabilitation of plant and equipment, tax, dividends on preference shares, under utilisation of productive capacity, effects of restrictions on monopoly, etc.

(vii) Determine the normal rate of return for the company, having particular regard to the nature and size of the undertaking.

(viii) Determine the appropriate capitalisation factor or the multiplier based on normal rate of return in the way discussed earlier.

(ix) Apply the multiplier obtained in (viii) above to the adjusted projected taxed income to arrive at the capitalised value of the undertaking.

(x) Divide the result in (ix) above by the number of equity shares to arrive at the value per share.

In this context, it may be noted that very often companies have non-trading assets like investments, and sometimes idle assets in their balance sheets. The income from non-trading assets does not reflect the earning power of the company and consequently that part of income should be taken out of consideration in determining the average maintainable profit. Also, the value of non-trading and idle assets, after proper determination, should be excluded in the determination of net worth at each stage. But non-trading assets should be added to the value of undertaking as obtained in (ix) above.