Valuing Shares Laura Fallon

How do you calculate the fair value of a share? ‘Fair value’ if we go to the definition given in IFRS 13 is ‘the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between willing and knowledgeable market participants at the measurement date’. So, as with all fair values, the fair value of a share is how much someone is willing to pay for it.  

For some shares, generally those actively traded on stock markets, working out how much someone is willing to pay for it is easy. Lots of people pay for these shares all the time and their price is readily available online or in a newspaper. Where local authorities own shares for treasury management purposes these are commonly shares in money market funds, cash plus funds or strategic pooled funds. Money market fund shares almost always have a fair value equal to the cash invested. For the other funds these may have prices that are quoted on exchanges, or otherwise the value is available from the fund manager who will know what price has recently been paid for shares traded. 

As with many aspects of local authority accounting, the calculation can be a bit more difficult for shares owned for service, or occasionally commercial, reasons. ‘Shares’ of course means that the local authority owns part of the company and is entitled to the future profits that the company will earn*. The most common context of this is where local authorities own, or part own in partnership with other organisations, subsidiary companies, joint ventures or partnerships. 100% owned subsidiaries are common, but many authorities also own smaller percentages of larger companies right down to only owning 1% or 2% of the company. These are normally within or near to the local authority’s area. Common examples include (but are not limited to) property companies, companies to build the infrastructure around properties, airports and energy companies. Purchasing shares is in most cases a way of providing funding for a service purpose: shares will give the company more flexibility around repayments than a loan and will usually mean the local authority can reap the full rewards of any profits made. In some instances, a local authority may invest money to help a local business in exchange for shares.  

What these investments usually have in common is that nobody has bought or sold them recently. These are often in small and newly formed companies, concentrated within a small geographical area. This means that you cannot rely on an easily available price like you can for most shares for treasury management purposes. So how do you tell how much someone else (such as a venture capitalist, bank or Joe Bloggs up the road) might be willing to pay for such an investment? In this context you are also looking at the value as an arm’s length market transaction: so, this is the value paid by an investor who wants to make money rather than to do something nice. 

The answer is that you have to make a sensible guess, but one that is as much as possible based on objective information and not your own opinion. There is more than one way of doing this. Valuing companies can be regarded as a whole discipline in itself, with books devoted to the subject**. The main premise however is that an investor is looking to earn money from the future dividends of the company: if you can estimate these can you estimate the company’s value. Estimating future dividends from a company is more complicated than estimating future income from a loan. In a loan (normally) you are expecting set amounts of cash at set times, which you will get unless the borrower goes bust. For shares you may get nothing, or you may get millions, the timing of these amounts is unknown. This will especially be the case for new companies, where there’s little history of dividend payments to go on.  

Valuation can be more of an art than a science. Different methods can work better for different types of companies. Companies that are very asset heavy can rely on the value of those assets (less any liabilities) in their balance sheet for a large proportion or even all of their value. In some cases, companies that do not have a value can be compared to companies that do and these values used as a proxy. If you have had a sale of the company or part of the company in the recent past, that price, plus or minus any changes since, is likely to form the best basis for the value. In most other instances a discounted cash flow model, whereby future cashflows are estimated and then discounted for time value and uncertainty, is most suitable. As most companies also aim to exist and pay dividends ‘in perpetuity’ (ie. forever) there are methods that can be employed to put a current number to a ‘forever’ value.  

A further factor is that equity valuations will usually be a ‘level 3’ calculation in the fair value hierarchy meaning that they rely on unobservable inputs. By definition unobservable inputs are subjective, meaning there are lots of judgements to make and, were you so inclined, lots of ways to fiddle these judgements to make your company look like it’s worth more than it really is. To prevent this accounting practice requires you to disclose the key judgements used. You are also required to judge how sensitive the value is to these judgements: ideally small changes in assumptions will not result in wild fluctuations in value.  

Arlingclose has many years of experience in valuing a wide variety of shares owned by local authorities. We have read the books on how to do equity valuations so you don’t have to! Our expertise allows us to pick the most suitable valuation model and to judge what prudent assumptions should be made. We can provide a full schedule of workings and a summary of key judgements and their sensitivities.  

For more information on how Arlingclose can assist with share value calculations please contact Laura Fallon on or 07702 788303. 

* Although it is also possible to have shares that do not make you an owner of a company, or that do not fully entitle you to a share of future profit. These ‘hybrid’ products are in actuality part shares and part loans. The fair value of these can also be difficult to judge! 

** I know because I have read one of them. 

Related Insights

Expected Credit Loss Calculations

Time to Revisit Your MRP?

Auditing Local Authority Accounts