Liquidation value is the value that sellers of a failed business could expect to receive in exchange for the business’ physical assets. Intangible assets such as intellectual property and goodwill are not included in liquidation value.
Liquidation of a business is usually a forced sale that usually occurs quickly, without sufficient time to line up buyers for or properly auction off the failed business’ illiquid assets. Accordingly, the sale of illiquid physical assets in a liquidation scenario often occurs at a discount to the fair value of such assets.
Liquidation value is often considered the theoretical valuation floor of a going-concern business. When a public company is trading near or below (rare) its liquidation value, value investors might consider the company’s stock a good buy.
Key Concepts of Liquidation Value
- Step-by-Step Process to Liquidation Value
- Uses in Finance and Valuation
- Limitations
- Liquidation Value vs. Book Value
- A Sample Calculation
- An Example from Retail
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Steps to Establishing Liquidation Value
Determining the liquidation value for a company involves several steps.
- Establish Fair Market Value: Make a list of all physical assets and determine their fair market value using replacement costs. Examples of items to include are: properties, manufacturing facilities, inventory, equipment, vehicles, and furniture.
- Estimate Discounts: To accurately reflect the urgency of the liquidation, it is important to adjust the estimated market values downwards. This adjustment typically involves applying discounts from 10-40% off the fair market value.
- Determine Liabilities: To properly handle the company’s liabilities, it is essential to establish a priority order and determine the amounts owed. This includes assessing secured debts, unsecured debts, and any outstanding accounts payable.
- Net Estimated Liquidation: To calculate the net estimated liquidation value, simply deduct the total liabilities from the adjusted tangible asset values.
Factors impacting the liquidation discount rate include:
- Severity of the company’s financial distress: Higher discounts for dire scenarios.
- Nature of assets: Commodities like inventory will sell at lower discounts than specialized equipment.
- Current economic environment: Discounts will be higher in recessions vs. expansions.
- Timeline to complete liquidation: Longer timelines allow for better asset sales.
Uses of Liquidation Value in Finance and Valuation
The liquidation value of a highly distressed company serves as an estimate of its minimum base valuation. It represents the remaining value if the company were to cease operations completely. When a company trades below its liquidation value, it indicates that the operating business is viewed as having negative value.
Value investors may view healthy companies trading near liquidation value as attractive investment opportunities. The current market capitalization approximates the liquidated value, so there is minimal downside risk.
In bankruptcy cases, the liquidation value is used to determine how much cash is available to repay creditors. The order of priority for repayment is based on which creditors hold secured claims backed by collateral assets.
Limitations of Liquidation Value
Liquidation Value does not consider the worth of intangible assets or the company as a lasting entity. It overlooks the importance and potential value of brands, intellectual property, and goodwill.
Determining the exact liquidation value is not a precise science. Estimating the worth of physical assets and liabilities can be challenging, particularly when trying to predict this value before an actual liquidation occurs.
The process of liquidating assets is not as straightforward as it may seem. It entails significant time, costs, and complexity. The necessary legal, administrative, and logistical measures can quickly accumulate expenses.
The demand for used assets may not meet expectations, as the inventory of liquidated assets from closed facilities could surpass the market’s ability to absorb them.
Liquidation value serves most effectively as a rough lower bound estimate rather than an exact single point valuation. It is best used as one input in a multi-faceted valuation approach.
Liquidation Value vs. Book Value
Book value and liquidation value have several key differences:
- Book value is calculated using the historical cost of assets, whereas liquidation value takes into account current market rates.
- Book value includes intangible assets, liquidation value does not.
- Book value may utilize accelerated depreciation that reduces asset valuation over time, whereas liquidation value uses current asset appraisals.
- Book value is not discounted, whereas liquidation values take into account discounts for forced sale situations.
- Book value is an accounting concept, while liquidation value aims to represent current economic value.
Liquidation value is typically lower than book value because it provides a more realistic assessment of the tangible assets’ worth in an actual business shutdown.
Sample Liquidation Value Calculation
Below is a simplified example liquidation value estimate. In this example, the value of the assets, taking into account liquidation and discounted costs, is estimated to be $5.95 million, while the book value stands at $11 million. This showcases how asset discounting and liquidation expenses can significantly affect the overall value.
Assets
Cash: $5 million
Accounts Receivable: $2 million
Inventory: $1 million
Equipment: $500,000
Real Estate: $2.5 million
Total Assets: $11 million
Discounted Asset Values
Cash: $5 million (no discount)
Accounts Receivable: $1.8 million (10% discount)
Inventory: $800,000 (20% discount)
Equipment: $400,000 (20% discount)
Real Estate: $2.25 million (10% discount)
Total Discounted Assets: $10.25 million
Liabilities
Accounts Payable: $1 million
Debt: $3 million
Total Liabilities: $4 million
Liquidation Costs: $300,000 (3% of total assets)
Liquidation Value = Discounted Assets – Liabilities – Total Liquidation Costs
$5.95 million = $10.25 million – $4 million – $300,000
An Example in Liquidation Value from Retail
The retail clothing company operates a total of 40 stores. On average, each store holds $200,000 worth of inventory, $100,000 worth of fixtures and equipment, and $50,000 worth of furnishings.
At their full price, the assets would amount to $14 million. Here’s how it breaks down:
40 stores x ($200,000 + $100,000 + $50,000) = $14 million
However, in a forced liquidation, the inventory may only fetch 25% of its original cost, the fixtures may sell at 50% of their book value, and the furnishings might only amount to 10% of their recorded worth.
If you take into account a 30% liquidation discount, the estimated liquidation value would be:
Inventory: 40 x $200,000 x 25% x 70% = $1.4 million
Fixtures: 40 x $100,000 x 50% x 70% = $1.4 million
Furnishings: 40 x $50,000 x 10% x 70% = $140,000
Total Liquidation Value = $2.94 million
Due to asset discounts and liquidation costs, the liquidation value of this is significantly lower than its book value of $14 million. This exemplifies why the liquidation value is typically only a small portion of the balance sheet book value.
Liquidation’s Relationship to Valuation
Liquidation value serves a specific purpose in valuation. It represents the minimum expected value that can be recovered from physical assets in the event of a business liquidation. While it’s not perfect, it provides a useful benchmark in certain situations such as financial distress or bankruptcy. When combined with other valuation methods, such as discounted cash flow analysis and market comparisons, liquidation value can provide valuable insights for investment analysis and risk assessment.
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