VALUATION CONCEPTS AND METHODOLOGIES

Chapter 3

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 the estimated going–concern value
greater than the liquidation value. However, if there are
circumstances that occur that doubt 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

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.
For example, in the case of 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 they can fetch if buyers buy these
assets separately. If these assets are sold separately, there is
no guarantee that they can generate future cashflows
anymore as they once did when it was used in the hotel.
Hence, their value is significantly reduced 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 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
machinery unless they 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 future cash flows which will result in value that is
higher than if the assets are just separately 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. 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 difficult to obtain as these are not
readily available. Instead, liquidation values 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

The below list shows circumstances wherein liquidation

value will be more appropriate in valuation exercises:
 BUSINESS FAILURES
 CORPORATE OR PROJECT END OF LIFE
 DEPLETION OF SCARCE RESOURCES
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.
BUSINESS FAILURES
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
Business failures can be driven by different internal factors such as
management, 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 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 pandemic or general health hazards
BUSINESS FAILURES
Liquidation value can be used for businesses that are closing,
are closed, are in bankruptcy, are in industries that are in
irreversible trouble, or goingconcern 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 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 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 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, the 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

Liquidation value is the most conservative valuation approach

among all as it considers the realizable value of the asset if it is
sold based on current conditions. This captures any markdowns
(or markups) that potential buyers negotiate to buy the assets.
GENERAL PRINCIPLES ON LIQUIDATION VALUE

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

General concepts considered in liquidation value are as follows:

 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.
Liquidation value method can also be used as a 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 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.
TYPES OF LIQUIDATION
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, auditors) and taxes at the end
of the transaction. These necessary expenses affect the final
value of the business.
TYPES OF LIQUIDATION
Assets are sold strategically over an orderly period to attract
and generate the most money for the assets is known to be an
orderly liquidation. This liquidation process will expose assets
for sale on the open market, with a reasonable time allowed to
find 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 is willing, but not compelled, to buy.
TYPES OF LIQUIDATION
Liquidation process, at which the asset or assets are sold as
quickly as possible, such as at an auction. This is known as
forced liquidation. 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 results in
lower prices because of the rush sale. This ultimately drives
down 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
Present Value of Sale of Asset Php
xxx.xx
Less: Present Value of Cost for termination
and Settlement for liabilities
( xxx.xx)
Less: Present Value of Tax Charges for the
Transactions and Other Liquidation Costs ( xxx.xx)
Liquidation Value
Php xxx.xx
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.
CALCULATING LIQUIDATION VALUE
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 the
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.
CALCULATING LIQUIDATION VALUE
Special consideration should be emphasized for intangible assets like
patents and internally developed software programs which are often
unsaleable. When a 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 offset 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, the individual valuation may be
impractical.
Illustrative Example 1
Pavement Company reported below balances based on its accounting books 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
Prepared 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
Illustrative Example 1
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 computed for the adjusted value of the assets, the current
book values 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 value (or net asset value).
Illustrative Example 1

Asset Valued at Asset In Php Book Value Valued at Asset

Adjusted
Value
Cash
100%
Cash 100,000 100% 100,000

A/R – Net 800,000 85% 680,000

A/R – Net 85% Inventories 3,500,000 60% 2,100,000
Inventories 60%
Prepaid 100,000 25% 25,000
Expenses
Prepaid PPE – Net 4,500,000 60% 2,700,000
25%
Expenses Total Assets 9,000,000 5,605,000
PPE – Net 60%
Illustrative Example 1

Asset Adjusted Value Php 5,605,000

Less: Total liabilities to be settled 2,000,000
Liquidation Value-Pavement Company Php 3,605,000
Number of Outstanding Shares 250,000
Liquidation Value per Share Php 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.
Net Cash Flow expected during the years it still operates is at
Php3,000,000 per year. At the end of its life, Golda is estimated to incur
Php10,000,000 for closure and rehabilitation costs for its mining site and
other costs related to the liquidation process. The cost of capital is set at
10%. The remaining assets by the end of the corporate life will be bought
by another company for Php30,000,000 and the remaining debt of
Php4,000,000 will be fully paid off by then. If the valuation happens now,
compute for the value of Golda Company.
Illustrative Example 2
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 Net Cash Flow and this will form part of its
value.
Illustrative Example 2
Present Value (PV) of Cash Inflows during Years in Operation
PV of Annual Net Cash Flow = Net Cash Flow × PV Factor of 10%

PV of Net Cash Flow (Year 1) = Php 3,000,000 × 0.9091 = Php 2,727,273

PV of Net Cash Flow (Year 2) = Php 3,000,000 × 0.8264 = Php 2,479,339

PV of Net Cash Flow (Year 3) = Php 3,000,000 × 0.7513 = Php 2,253,944

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

2) + PV of NCF (Year 3
PV of Cash Inflows during Years in Operation = Php 2,727,273 + Php 2,479,339 + Php
2,253,944
PV of Cash Inflows during Years in Operation = Php 7,460,556
Illustrative Example 2
Since corporate life ends by Year 3, terminal value will be based on the
liquidation value by end of Year 3.

Present Value of Asset Php 22,539,000

(Php 30,000,000 × 0.7513)
Less: Present Value of Cost for termination
and settlement for Liabilities
(Php 10,000,000 × 0.7513) 7,513,000
Less: Present Value of Tax Charges for the
Transactions and Other Liquidation Costs
(Php 4,000,000 × 0.7513) 3,005,200
Liquidation Value Php 12,020,800
Illustrative Example 2
Cash Flows during the remaining operating life and liquidation value by
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 Years in Operation + Liquidation

Value
Value of Golda Company = Php 7,460,556 + Php 12,021,037
Value of Golda Company = Php 19,481,593
Illustrative Example 3
Droid Company's balance sheet revealed total assets of Php 3
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 Php 300,000 will also be incurred to
cover liquidation expenses. How much is the liquidation value
of Droid Company per share?
Illustrative Example 3
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 = Php 1,800,000 - Php 1,000,000 - Php 300,000
Liquidation Value = Php 500,000

Liquidation Value per Share = Liquidation Value / Number of Outstanding

Ordinary Shares
Liquidation Value per Share = Php 500,000 / 100,000 shares
Liquidation Value per Share = Php 5.00 per share