CHAPTER 3: LIQUIDATION BASED VALUE

- External Factors:
LIQUIDATION VALUE
- According to the CFA Institute, it is the value of a INSOLVENCY BANKRUPTCY
company if it were dissolved and its assets were - Inability to pay liabilities - Happens when liabilities
sold individually. when they fall due. become greater than asset
balance.
- Represents the net amount that can be gathered if
the business is shut down and its assets are sold
ASSETS > LIABILITIES
piecemeal.
ASSETS < LIABILITIES
- Also know as net asset value.
- Asset balance is still - Inability to pay liabilities
 NOTE: Circumstances clearly dictates greater than its liabilities but unless the assets can be sold
whether it will be appropriate to use is having liquidity problems at a higher price than its book
liquidation value or going concern value as a result of depleted cash. value.
in a valuation exercise. o Severe Economic Downturn
 If a business is profitable or has o Dynamic Consumer Preferences
sustainable growth prospects, these will o Material Adverse Governmental Action or
normally show future cash flows which Regulation
will result in the firm value that is higher o Occurrence of Natural Disasters or
than if the assets are just separately like in
Calamities
a liquidation.
o Occurrence of Pandemic or General
Health Hazard
- LIQUIDATION VALUE > GOING CONCERN
VALUE = a significant business event transpired
which makes the liquidation value more  NOTE: Liquidation value can be used for
appropriate in valuation exercise. businesses which are:
 Closing
- Liquidation Value – is the base or the floor price  Are closed
for any firm valuation exercise.
 Are in bankruptcy
o Should not be used to value profitable or  Are in industries that are in
irreversible trouble
growing companies as this approach does
not consider growth prospects of the
 Or going concern firms that isn’t
putting its assets to good use and
business.
may be better off closing down
o Instead, liquidation value should be used and selling the assets.
for dying or losing companies where
liquidation is imminent to check whether 2.) Corporate or Project End of Life
profits can still be realized upon sale of - Corporations with a finite number of years to
the assets owned. operate as stated in their Articles of Incorporation.
- Once the date arrives, and life is not extended, the
- Liquidation Prices - can be difficult as these are corporation ends and the liquidation process starts.
not readily available. - Is corporate end of life is already certain, it is more
appropriate to compute terminal value using
SITUATIONS TO CONSIDER LIQUIDATION VALUE liquidation value.

3.) Depletion of Scarce Resources

1.) Business Failures
- Used in some industries like mining and oil where
- The most common reason why businesses close or the availability of scarce resources significantly
liquidate. influences firm value.
- Early Symptoms – low or negative returns, or - These are industries that are highly regulated by the
when the firm earns return at a rate lower than its government.
cost of capital. - Once the contract with the government expires, or
- When left unresolved, this may lead to insolvency the scarce resource becomes fully depleted, this
or even bankruptcy. might signal potential liquidation.

- Internal Factors: GENERAL PRINCIPLES OF LIQUIDATION VALUE

o Mismanagement - Liquidation value – is the most conservative
valuation approach among all
o Poor Financial Evaluation and Decisions o It considers the realizable value of the
o Failure to execute strategic plans asset if it is sold now based on current
o Inadequate Cash Flow Planning conditions.
o Failure to Manage Working Capital
 o This captures any markdowns (or  NOTE: if the company can be readily
markups) that potential buyers negotiate liquidated any time, market price per share
to buy the assets. should never be below book value per
share if all reported assets in the balance
- General concepts considered in liquidation value are sheet is accurate.
as follows:
 If the liquidation value is above income TYPES OF LIQUIDATION:
approach valuation (based on going-concern 1.) Orderly Liquidation
principle) and liquidation comes into - Assets are sold strategically over an orderly period
consideration, liquidation value should be to attract and generate the most money for the
used. assets.
- This process will expose assets for sale on the open
 If the nature of the business implies limited market, with a reasonable time allowed to find a
lifetime (e.g., a quarry, gravel, fixed-term purchaser, both buyer and seller having knowledge
company etc.), the terminal value must be of the uses and purposes to which the asset is
based on liquidation. adapted and for which it is capable of being used,
the seller being compelled to sell and the buyer
willing, but not compelled, to buy.
 All costs necessary to close the
operations (e.g., plant closure costs, 2.) Forced Liquidation
disposal costs, rehabilitation costs) - Liquidation process, at which the asset or assets are
should also be factored in and sold as quickly as possible, such as at an action.
deducted to arrive at the liquidation
value. CALCULATING LIQUIDATION VALUE
- Liquidation value - considers the present value of
 Non-operating assets should be valued by the sums that can be obtained through the disposal
liquidation method as the market value is of the assets of the firm in the most appropriate
reduced by costs of sale and taxes. way, net of the sums set aside for the closure costs,
repayment of the debts and settlement of all
 Since they are not part of the firm's liabilities and net of the tax charges related to the
operating activities, it might be transaction and the costs of the process of
inappropriate to use the same going liquidation itself.
concern valuation technique used for - Liquidation value can be further computed on a
business operations. If such result is per share basis by dividing total liquidation value
higher than net present value of cash by outstanding ordinary shares.
flows from operating the asset, the
liquidation value should be used.
 NOTE: Calculation for liquidation value
at closure date is somewhat like the book
 Liquidation valuation must be used if the value calculation, except the value
business continuity is dependent on current assumes a forced or orderly liquidation
management that will not stay. value.
- Liquidation value method can also be used as - Book value should not be used as liquidation value.
benchmark in making investment decisions o Liquidation value can be obtained based
o When a company is profitable with good on the potential sales price of the assets
industry outlook, the liquidation will being sold instead of relying on the costs
typically be lower than the prevailing recorded in the books.
market price of the share. - Liquidation value
o Is far more realistic as compared to the
PROFITABLE: LIQUIDATION < PREVAILING book value method.
MARKET PRICE
o Can be used as a basis for terminal cash
o For the firms that are experiencing decline flow (instead of going concern terminal
or industry is consistently declining, cash flow) in a DCF calculation in order to
prevailing share prices might be lower compute firm value in case there are years
than liquidation value. that the firm will still be operational prior
o If this happens, the rational to liquidation.
decision for the business is to
permanently close the business o Estimation of liquidation values will be
and liquidate its assets. complex if assets cannot be easily
identified or separated; hence, individual
NOT PROFITABLE: LIQUIDATION > PREVAILING valuation may be impractical.
MARKET PRICE