Liquidation-based Valuation
For most companies, the value generated by assets working together and by human capital
applied to managing those assets makes the estimated going-concern value greater than the
liquidation value. 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.
According to the CFA Institute, liquidation value refers to the value of a company if it were
dissolved and its assets are 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.
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 (ex. perishable assets). Businesses can wait longer periods to sell other assets
like buildings or machinery unless they are other constraints that will require them to be disposed
of in a shorter time.
Circumstances clearly dictate 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 future cash flows which will result in a firm value that is
higher than if the assets are just sold separately like in a liquidation.
However, if the liquidation value becomes higher compared to going concern value, this
may signal that a significant business event transpired which makes the liquidation value more
appropriate in the valuation exercise.
Liquidation value is the base price or the floor price for any firm valuation exercise. Liquidation
value should not be used to value profitable or growing companies as this approach does
not consider the growth prospects of the business.
Liquidation prices can be 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 the 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 partners'
pecific 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
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 that 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 a 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.
These external factors that would attribute to business failure may take the form of, but are not
limited to the following:
● Severe economic downturn
● Dynamic consumer preferences
● Material adverse governmental action or regulation
● Occurrence of natural disasters or calamities
● Occurrence of a pandemic or general health hazards
Liquidation value can be used for businesses that are closing, are closed, are in bankruptcy, are
in industries that are in irreversible trouble, or going concern firms that aren't putting their 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 or Project End of Life
Most corporations only have a 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 a finite life. Once
the date arrives and life is 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 a collective decision of shareholders to stop the
operation and realize value by liquidating the company instead. If the corporate end of life is
already certain, it is more appropriate to compute terminal value using liquidation value.
For most companies, the value generated by assets working together and by human capital
applied to managing those assets makes the estimated going-concern value greater than the
liquidation value. 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.
According to the CFA Institute, liquidation value refers to the value of a company if it were
dissolved and its assets are 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.
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 (ex. perishable assets). Businesses can wait longer periods to sell other assets
like buildings or machinery unless they are other constraints that will require them to be disposed
of in a shorter time.
Circumstances clearly dictate 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 future cash flows which will result in a firm value that is
higher than if the assets are just sold separately like in a liquidation.
However, if the liquidation value becomes higher compared to going concern value, this
may signal that a significant business event transpired which makes the liquidation value more
appropriate in the valuation exercise.
Liquidation value is the base price or the floor price for any firm valuation exercise. Liquidation
value should not be used to value profitable or growing companies as this approach does
not consider the growth prospects of the business.
Liquidation prices can be 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 the 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 partners'
pecific 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
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 that 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 a 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.
These external factors that would attribute to business failure may take the form of, but are not
limited to the following:
● Severe economic downturn
● Dynamic consumer preferences
● Material adverse governmental action or regulation
● Occurrence of natural disasters or calamities
● Occurrence of a pandemic or general health hazards
Liquidation value can be used for businesses that are closing, are closed, are in bankruptcy, are
in industries that are in irreversible trouble, or going concern firms that aren't putting their 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 or Project End of Life
Most corporations only have a 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 a finite life. Once
the date arrives and life is 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 a collective decision of shareholders to stop the
operation and realize value by liquidating the company instead. If the corporate end of life is
already certain, it is more appropriate to compute terminal value using liquidation value.
