Liquidation-Based

Valuation

Module 8: Valuation and Concepts

 Liquidation- Situations to
Lecture Content
Liquidation Consider
Based Value
Valuation Liquidation
Value

Uses of
General Liquidation Calculating
Principles on Value in Liquidation
Liquidation Investment Value
Value Analysis
Liquidation-Based
Valuation
Liquidation-Based Valuation
For most companies, the value generated by assets
working together and by human capital applied to
managing those assets makes estimated going - concern
value greater than liquidation value. This captured in the
free cash flow forecasts and other items that are
considered and calculated in the previous modules.
However, if there will be circumstances that occur which
doubts the going-concern ability of a business, using
going-concern value may not be appropriate anymore as
the future cash flows will not be realizable anymore. An
alternative approach is the use of liquidation value.
Liquidation Value
 Liquidation Value
According to the CFA Institute, liquidation value refers to the value of
a company if it were dissolved and its assets sold individually.
Liquidation value represents the net amount that can be gathered if
the business is shut down and its assets are sold piecemeal. In
some texts, liquidation value is also known as net asset value.

For example, if a hotel closes, the assets it owns like beds, chairs,
furniture and kitchen equipment can be sold as part of a package or
separately. These assets are priced based on the value it can fetch if
buyers buy these assets separately. If these assets will be sold
separately, there is no guarantee that they can generate future cash
flows anymore as it once did when it was used in the hotel. Hence,
their value is significantly downgraded to its liquidation value.
 Liquidation Value
Once a business closes, synergies generated by assets working
together or by applying managerial skill to these assets are lost
which reduces firm value. In addition, liquidation value may continue
to erode based on the time frame available for liquidating assets. For
example, perishable inventories should be sold immediately or else it
cannot be sold anymore if it gets spoiled. Businesses cannot afford
to wait for potential buyers that are appropriate choice is to sell it at a
willing to pay higher price. The most appropriate choice is to sell it at
a discount to recover some money from it instead of throwing it away
without recovering any money. Businesses can wait longer period to
sell other assets like building or machineries unless there are other
constraints that will require them to be disposed in a shorter time.
Liquidation Value
Circumstances clearly dictates whether it will be
appropriate to use liquidation value or going concern value
in a valuation exercise. If a business is profitable or has
sustainable growth prospects, these will normally show will
result in firm value that is higher than if the assets future
cash flows which will result in firm value that is higher than
if the assets are just separated like in a liquidation.

However, if liquidation value becomes higher compared

against going concern value, this may signal that a
significant business event transpired which makes the
liquidation value more appropriate in valuation exercise.
 Liquidation Value
Liquidation value is the base price or the floor price for any firm valuation
exercise. However, liquidation value should not be used to value profitable
or growing companies as this approach does not consider growth
prospects of the business. Liquidation prices can be also difficult to obtain
as these are not readily available. Instead, liquidation value should be used
for dying or losing companies where liquidation is imminent to check
whether profits can still be realized upon sale of the assets owned.

A unique callout for liquidation value is if the firm is operating under a

proprietorship or a partnership model. In these two forms of organization
profits and cash flows are highly dependent on the skills, knowledge, ability
or network of the owner or partners. As a result, liquidation value should
consider valuing separately the goodwill attributed to these partner-specific
qualities as this may not reflect the true value of the assets which will be
sold or transferred. In this scenario where liquidation is the motive, goodwill
will reduce liquidation value.
 Situations to
Consider
Liquidation Value
 Situations to Consider Liquidation Value
The below list shows circumstances wherein liquidation value will be more
appropriate in valuation exercises:
 Business Failures
Business failure is the most common reason why businesses close or liquidate. Early
symptoms of business failure are low or negative returns. Companies which consistently
report operating losses will eventually impact and reduce firm value. If the firm only earns
return at a rate lower than its cost of capital, this might signal business failure. When left
unresolved, this may lead to insolvency or even bankruptcy.

Insolvency happens when a company cannot pay liabilities as they come due. Insolvent
firms have asset balance which is still greater than liabilities but is having liquidity
problems as a result of depleted cash. Bankruptcy is the most serious type of business
failure, as this happens when liabilities become greater than asset balance. As a result,
shareholders' equity becomes negative balance. This signifies that the firm cannot settle
all its liabilities unless the assets can be sold at a higher price than its book value (which
is not often the case).
Situations to Consider Liquidation Value
 Business Failures (continued)

Business failures can be driven by different internal factors such as

mismanagement, poor financial evaluation and decisions, failure to execute
strategic plans, inadequate cash flow planning or failure to manage working
capital. External factors such as severe economic downturn, occurrence of
natural calamities or pandemic, changing consumer preferences and adverse
governmental regulations may also contribute to business failure.

Liquidation value can be used for businesses who are closing, are closed, are in
bankruptcy, are in industries that are in irreversible trouble, or going concern
firms that isn't putting its assets to good use and may be better off closing down
and selling the assets. For distressed companies, the liquidation value conveys
relevant information as it is typically the lower bound of the valuation range.
Situations to Consider Liquidation Value
 Corporate/Project End of Life

Most corporations only have finite number of years to operate as stated in

their Articles of Incorporation. This is also similar in the case of projects like
joint ventures with finite life. Once the date arrives and the life as not
extended, due process takes place to end the life of the corporation and start
the liquidation process. Non-extension of corporate life may stem from
collective decision of shareholders to stop the operation and realize value
from liquidating the company instead. If corporate end of life is already
certain, it is more appropriate to compute terminal value using liquidation
value.
Situations to Consider Liquidation Value
 Depletion of Scarce Resources

In some industries like mining and oil, availability of scarce resources

significantly influences firm value. Oftentimes, these are also industries that
are highly regulated by the government. Government regulation often
requires that companies seek approval from the government prior to
commencement of operations. Once the contract with the government
expires or scarce resource become fully depleted and no new site is
prepared to support operation, this might signal potential liquidation and
valuation should be based on liquidation value.
General Principles
on Liquidation
Value
 General Principles on Liquidation Value
Liquidation value is the most conservative valuation approach
among all as it considers the realizable value of the asset if it is sold
now based on current conditions. This captures any markdowns (or
mark-ups) that potential buyers negotiate to buy the assets.

General concepts considered in liquidation value are as follows:

 If the liquidation value is above income approach valuation
(based on going-concern principle) and liquidation comes into
consideration, liquidation value should be used.
 If the nature of the business implies limited lifetime (e.g. a quarry,
gravel, fixed-term company, etc.), the terminal value must be
based on liquidation. All costs necessary to close the operations
(e.g. plant closure costs, disposal costs, rehabilitation costs)
should also be factored in and deducted to arrive at the liquidation
value.
General Principles on Liquidation Value
 Non-operating assets should be valued by liquidation
method as the market value reduced by cost of sale
and taxes. Since they are not part of the firm’s
operating activities, it might be inappropriate to use the
same going concern valuation technique used for
business operations.

 Liquidation value must be used if the business

continuity is dependent on current management that
will not stay.
 Uses of
Liquidation Value
in Investment
Analysis
Uses of Liquidation Value in Investment Analysis

For analysts, liquidation value method can also be used as

benchmark in making investment decisions. When a
company is profitable with good industry outlook, the
liquidation will typically be lower than the prevailing market
price of the share. Share price can often reflects growth
prospects of the company which is a consideration that
liquidation value does not have.
 Uses of Liquidation Value in Investment Analysis
For firms that are experiencing decline or industry is consistently
declining, prevailing share prices might be lower than liquidation
value. If this happens, the rational decision for the business is to
permanently close the business and liquidate its assets. Some
corporate investors tend to look for companies whose shares exhibit
this characteristic. Because liquidation value is higher than market
price of share, these corporate investors buy the shares at prevailing
market price and sell the company at the higher liquidation value.
This results in risk-free arbitrage profit for these corporate investors.

However, if the company can be readily liquidated any time, market

price per share should never be below book value per share if all
reported assets in the balance sheet is accurate.
 Calculating
Liquidation Value
 Calculating Liquidation Value
The liquidation value considers the present value of the sums that
can be obtained through the disposal (i.e., sale) of the assets of the
firm in the most appropriate way, net of the sums set aside for the
closure costs, repayment of the debts and settlement of all liabilities,
and net of the tax charges related to the transaction and the costs of
the process of liquidation itself. Liquidation value can be further
computed on a per share basis by dividing total liquidation value by
outstanding ordinary shares. Liquidation value per share should be
considered together with other quantitative (e.g. current share price,
going concern DCF) and qualitative metrics to justify business
decisions to be made.
 Calculating Liquidation Value
Determining the type of liquidation that will occur is important because it will affect
the costs connected with liquidation of the property, including commissions for
those facilitating the liquidation (lawyers, accountants and auditors) and taxes at
the end of the transaction. These necessary expenses affect the final value of the
business.
 Orderly liquidation. Assets are sold strategically over an orderly period to
attract and generate the most money for the assets. This liquidation process
will expose assets for sale on the open market, with a reasonable time allowed
to find a purchaser, both buyer and seller having knowledge of the uses and
purposes to which the asset is adapted and for which it is capable of being
used, the seller being compelled to sell and the buyer being willing, but not
compelled, to buy.

 Forced liquidation. Liquidation process, at which the asset or assets are sold as
quickly as possible, such as at an auction. Liquidation is done immediately
especially if creditors have sued or a bankruptcy is filed. Assets are sold in the
market at the soonest time possible which result in lower prices because of the
rush sale. This ultimately drives down liquidation value.
 Calculating Liquidation Value
Calculation for liquidation value at closure date is somewhat like the
book value calculation, except the value assumes a forced or orderly
liquidation of assets instead of book value. Book value should not be
used as liquidation value. Liquidation value can be obtained based on
the potential sales price of the assets being sold instead of relying on
the costs recorded in the books. Liquidation value is far more realistic
as compared to the book value method. Even if these assets generate
lower than expected return in the present business, liquidation value
should be based on the potential earning capacity of the individual
asset when sold to the buying party instead of the original capital
invested in the assets.

In practice, the liabilities of the business are deducted from the

liquidation value of the assets at closure to determine the liquidation
value of the business. The overall value of a business that uses this
method should be lower than going-concern value.
 Calculating Liquidation Value
In computing for the present value of a business or property on a liquidation basis,
the estimated net proceeds should be discounted at a rate that reflects the risk
involved back to the date of the original valuation. This is important to ensure that
all assumptions are aligned. Liquidation value can be used as basis for terminal
cash flow (instead of going concern terminal cash flow) in a DCF calculation in
order to compute firm value in case there are years that the firm will still be
operational prior to liquidation.

Special consideration should be emphasized for intangible assets like patents and
internally developed software programs which are often unsaleable. When
takeover occurs, it is usual that goodwill is recognized as part of the transaction.
Monetary equivalent specific for intangible assets cannot be reliably and
separately measured. Instead, intangible assets are onset against shareholder's
equity to come up with a conservative liquidation value.

Estimation of liquidation values will be more complex if assets cannot be easily

identified or separated; hence, individual valuation may be impractical.
 Calculating Liquidation Value
Illustrative Example 1

Pavement Company reported below balances based on its accounting book records.
Pavement Company has 250,000 outstanding shares.
 Calculating Liquidation Value
Pavement Company is undergoing financial problems and management would like to assess
liquidation value as part of their strategy formulation. If assets will be sold/realized, they will
only realize amount based on below table.

To compute for the adjusted value of the assets, the current book value should be multiplied
by the assumed realizable value if they are liquidated. Next, the liabilities should be deducted
from the asset adjusted value to arrive at the liquidation (or net asset value).
 Calculating Liquidation Value
Illustrative Example 2

Golda Company, which is a company specifically created for a joint venture

agreement to extract gold, will end its corporate life in 3 years. Free cash flow
expected during the years it still operates is at Php3,000,000 per year. At the end
of its life, Golda estimates to incur Php10,000,000 for closure and rehabilitation
costs for its mining site and other costs related to the liquidation process. Cost of
capital is set at 1 0%. Remaining assets by end of the corporate life will be bought
by another company for P30,000,000 and remaining debt of P4,000,000 will be
fully paid off by then.

If the valuation happens now, compute for the value of Golda Company.

Since Golda Company will terminate its life after 3 years, it is more appropriate to
use liquidation value as terminal value input to the DCF model. For the three years
prior to the closure, Golda Company will continue to generate positive free cash
flow and this will form part of its value.
 Calculating Liquidation Value
Present Value (PV) of Cash Inflows during Years in Operation
PV of Annual Free Cash Flow: Free Cash Flow x PV Factor of 10%

PV of Free Cash Flow (Year 1) = Php3,000,000 x 0.9091 = Php2,727,273

PV of Free Cash Flow (Year 2) = Php3,000,000 x 0.8624 = Php2,479,339
PV of Free Cash Flow (Year 3) = Php3,000,000 x 0.7513 = Php2,253,944

PV of Cash Inflows during Years in Operation = PV of FCF (Year 1) + PV of FCF

(Year. 2) + PV of FCF (Year 3)
PV of Cash Inflows during Years in Operation = Php2,727,273 + Php2,479,339 +
Php2,253,944
PV of Cash arrows during Years in Operation = Php7,460,556

Since corporate life ends by value will be based on the liquidation value by end of
Year 3.
 Calculating Liquidation Value
Liquidation Value = PV of Sale of Assets – PV of Closure Costs and Payment for
Liabilities
Liquidation Value = (Php30,000,000 – 0.7513) – [(Php10,000,000 +
Php4,000,000) x 0.7513]
Liquidation Value = Php22,539,444 – 10,518,407
Liquidation Value = Php12,021,037

Cash flows during the remaining operating life and liquidation value by the end of
Year 3 should be combined to arrive at the value of Golda Company now.

Value of Golda Company = PV of Cash Inflows during the Years in Operation +

Liquidation Value
Value of Golda Company = Php7,460,556 + Php12,021,037
Value of Golda Company = Php19,481,593
 Calculating Liquidation Value
Illustrative Example 3
Droid Company's balance sheet revealed total assets of Php3 million, total liabilities of Php1
million, and 100,000 shares of outstanding ordinary shares. Upon checking with potential
buyers, the assets of Droid can be sold for
Php1.8 million if sold today. Additional Php300,000 will also be incurred to cover liquidation
expenses. How much is the liquidation value of Droid Company per shared?

To compute for the liquidation value in this example, we need to consider how much the
company will receive from the assets if it will sell today. This money will also be used to pay for
the remaining liabilities and liquidation expenses.

Liquidation Value = Sale of Assets upon Liquidation - Payment for Liabilities - Liquidation Costs
Liquidation Value Php1,800,000 - Php1,000,000 - Php300,000
Liquidation Value = Php500,000

Liquidation Value per Share = Liquidation Value / Number of Outstanding Ordinary shares
Liquidation Value per Share = Php500,000 / 100,000 shares
Liquidation Value per Share = Php5.00 per share
Summary
 Summary
Liquidation value refers to the value of the company if it were dissolved and its assets sold
individually. Liquidation value represents the net amount that can be gathered if the business is
shut down and its assets are sold piece meal. Liquidation value is considered as the minimum
or floor value for any firm valuation exercise. Liquidation value is the most conservative
valuation among all approach among all as it considers the realizable value of the asset if it is
sold now based on current conditions.

Liquidation value is appropriate in the cases of business failures, end of life of the business or
project and depletion of scarce resources.

Liquidation value should be used:

 When liquidation value is greater than going concern value
 When business has finite life.
 To value non-operating assets.
 If business continuity is dependent on current management who will not stay.
 Summary
The liquidation value considers the present value of the sums that
can be obtained through the disposal (i.e. sale) of the assets of the
firm in the most appropriate way, net of the sums set aside for the
closure costs, repayment of the debts and settlement of all liabilities,
and net of the tax charges related to the transaction and the costs of
the process of liquidation itself.

For better appreciation of shareholders, liquidation value can be

divided by the number of outstanding ordinary shares to arrive at the
liquidation value per share. Liquidation value per share should
typically always be below market price per share in times of
profitable operations. If liquidation value per share exceeds market
price, this might signal significant downturn for the business.
 End of
Discussion