Capitalization of earnings

Most of a scheme's equity portfolio has a market price every day — whatever the stock exchange last quoted. Some holdings do not. A private placement, or a stock that simply has not traded, has no such price to use.

SEBI's rule fills that gap. Once a security has gone 30 days without trading on any stock exchange, it becomes a "non-traded" security for valuation purposes, and the AMC has to estimate its worth some other way.

One accepted method is capitalization of earnings: work out what a similar, actively traded company's shares sell for relative to its earnings, apply that same relationship to the non-traded company's earnings, and then knock a discount off — because a share nobody wants to trade is worth less than an identical one that trades freely.

The valuation principle (Chapter 7, non-traded securities): equity instruments are valued on the basis of capitalization of earnings, either alone or combined with net asset value, using the price-earnings ratios of comparable traded securities, with an appropriate discount for lower liquidity.

The method rests on peer comparison: find a listed company doing similar business, take its P/E ratio, and apply it to the non-traded company's own earnings to imply a value. The AMC's Board must approve the valuation methodology, the decision must be documented in Board minutes, and the supporting data for each security valued this way must be preserved for audit. The 30-day non-traded threshold is the trigger — until then, the last traded price is used; after it, capitalization of earnings (or a Board-approved alternative) takes over.

Illustrative — the workbook states the method, not a worked figure.

A scheme holds shares in an unlisted specialty chemicals company that last traded 35 days ago. It has crossed the non-traded threshold.

The AMC identifies a listed peer in the same sub-sector trading at a P/E of 18. The unlisted company's latest audited earnings per share is Rs 12.

Implied value before discount = 18 × Rs 12 = Rs 216 per share
Liquidity discount applied     = 20%
Valuation used                 = Rs 216 × (1 − 0.20) = Rs 172.80 per share

On a holding of 50,000 shares, that values the position at Rs 86.4 lakh in the scheme's NAV — a figure the AMC's Board must have approved the methodology for, and an auditor must review annually as fair and reasonable.

Chapter 7 (Net Asset Value, Total Expense Ratio and Pricing of Units) sets out the valuation of non-traded securities, of which capitalization of earnings is the prescribed method for equity. Expect a question on the 30-day threshold that triggers non-traded status, and on what capitalization of earnings actually uses — comparable P/E ratios, with a liquidity discount.

• 30 days is measured from the valuation date backward, on any stock exchange — trading on even one exchange keeps a security out of "non-traded" status.
• The discount is for illiquidity, not for business risk. It applies because the security cannot be sold quickly at that price, not because the company is weaker than its peer.
• Capitalization of earnings can be used alone or blended with net asset value — the workbook allows either.
• This is a different question from Fair valuation principles, which sets the Board-level policy framework; capitalization of earnings is one specific method used inside that framework for one asset class.