Chapter 3 Liquidation Based Valuation

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liquidation value

• (CFA) value of a company it was dissolved, and its assets are sold individually

• represents the net amount that can be gathered if the business is shut down and its assets are sold piecemeal

• aka net asset value

• base price or the floor price for any firm valuation exercise

• should not be used to value profitable or growing companies as this approach does not consider growth prospects of the business

• 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

• (unique) if firm is operating under a proprietorship or a partnership model

• most conservative valuation among all as it considers the realizable value of the asset it is sold now based on current conditions

• can also be used as benchmark in making investment decisions

situations to consider liquidation value

• business failures

• corporate/project end of life

• depletion of scarce resources

business failures

• most common reason why businesses close or liquidate

• early symptoms are low/negative returns

• 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

insolvency

happens when a company cannot pay liabilities as they come due

insolvent firm

have an asset balance which is still greater than liabilities but is having liquidity problems because of depleted cash

bankruptcy

most serious type of business failure as this happens when liabilities become greater than asset balance

external factors factors that would attribute to business failure may take the form of, but not limited to

• severe economic down-turn

• dynamic consumer preferences

• material adverse governmental action or regulation

• occurrence of natural disaster or calamities

• occurrence of pandemic or general health hazards

corporate/project end of life

• most corporations only have finite number of years to operate as stated in their articles of incorporation

• similar in the case of projects like joint ventures with finite life

• non-extension of corporation life may stem from collective decision of shareholders to stop the operation and realize value from liquidating the company instead

• if this is certain, it is more appropriate to compute terminal value using liquidation value

depletion of scarce resources

like mining and oil, availability of scarce resources significantly influences firm value

general principles on liquidation value

• If the liquidation value is above income approach valuation (going-concern principle) and liquidation comes into consideration, liquidation value should be used

• If the nature of the business implies limited lifetime, the terminal value must be based on liquidation. All costs necessary to close the operations 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 is reduced by costs 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 valuation must be used if the business continuity is dependent on current management that will not stay

orderly and forced liquidation

types of liquidation

orderly liquidation

• assets are sold strategically over an orderly period to attract and generate the most money for the assets

• 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

• which the asset or assets are sold as quickly as possible, such as at an auction

• 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

• ultimately dries down liquidation value