Module 8: Liquidation-Based Valuation

A. Lecture/Content:
 Liquidation-Based Valuation
 Liquidation Value
 Situations to Consider Liquidation Value
o Business Failures
o Corporate/Project End of Life
o Depletion of Scarce Resources
 General Principles on Liquidation Value
 Uses of Liquidation Value in Investment Analysis
 Calculating Liquidation Value
 Summary

B. 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.

C. 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.

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.

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 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.

D. 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).

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.

 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.

 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.

E. 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.
 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. If such result is higher than
net present value of cash flows from operating the asset, the liquidation value should be used.
 Liquidation value must be used if the business continuity is dependent on current management that will
not stay.

F. 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.

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.

G. 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.
 Liquidation Value = PV of Sale of Assets – PV of Closure Costs and Payment for Liabilities –
Tax Charges for the Transaction and Other Liquidation Costs

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.

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.

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.

Illustrative Example 1

Pavement Company reported below balances based on its accounting book records. Pavement Company has
250,000 outstanding shares.

Pavement Company
December 31, 2019
(in '000 Philippine Pesos)

Assets
Cash 100,000
Accounts Receivable (A/R) - net 800,000
Inventories 3,500,000
Prepaid Expenses 100,000
Property, Plant and Equipment (PPE) - net 4,500,000
Total Assets 9,000,000

Liabilities
Notes Payable 1,200,000
Other Liabilities 800,000
Total Liabilities 2,000,000

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 s 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).

Asset Valued At Asset (in PHP) Book Value Valued At Adjusted Value
Cash 100% Cash 100,000 100% 100,000.00
A/R Net 85% A/R Net 800,000 85% 680,000.00
Inventories 60% Inventories 3,500,000 60% 2,100,000.00
Prepaid Prepaid Expenses 100,000 25% 25,000.00
Expenses 25% PPE - Net 4,500,000 60% 2,700,000.00
PPE - Net 60% Total Assets 9,000,000 5,605,000
 Asset Adjusted Value 5,605,000
Less: Total Liabilities to be settled 2,000,000
Liquidation Value - Pavement Company 3,605,000
Number of Outstanding Shares 250,000
Liquidation Value per Share 14.42

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.

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.

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

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

H. 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 piecemeal. 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

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.