Liquidation Value Method of Equity Valuation

Liquidation value method of equity valuation is one of the techniques under Balance Sheet based methods of valuation which assumes that value of the company under this method will be its salvage value if the company is shut down.

The net worth or book value of the company reflects its accounting value while the liquidation value tends to arrive at the company’s residual value assuming that the company sells off all its assets (at market realizable value) and pays off all the liabilities that it has taken.

Let us now draw a comparison between book value, adjusted book value and liquidation value with the help of an example.

Example Comparing Book Value V/S Adjusted Book Value V/S Liquidation Value

Sample Balance Sheet

Liabilities $ (Mio) Assets $ (Mio)
Equity Share Capital 1500 Fixed Assets 3000
Preference Share Capital 600 Inventories 1350
Reserves and Surplus 300 Cash and Bank Balance 150
Long Term Debt 900 Debtors 300
Short Term Debt 300
Creditors 1200
Total 4800 Total 4800

The book value here will be $2400 Mio as per the below calculation:

Book Value Calculation $ Mio
Total Assets 4800
Less Long-Term Debt 900
Less Short Term Debt 300
Less Creditors 1200
Book Value 2400

Assuming market value of fixed assets being 50% higher than accounting value, adjusted book value here will be $3900 Mio which higher than the book value of $ 2400 Mio which we calculated earlier.

Adjusted Book Value Calculation $ Mio
Total assets (now higher) 6300
Less Long-Term Debt 900
Less Short Term Debt 300
Less Creditors 1200
Adjusted Book Value 3900

Liquidity value may slightly differ from the adjusted book value given the fact that when a company goes to sell off its assets, it may receive lesser value than the market value. Inventory might have piled up and since business needs to be closed down, inventory may even fetch a lower value. Furthermore, there might be some expenses incurred on liquidation which also can be taken into account to arrive at fair liquidation value.

Assuming a distress selling loss of 20% on inventory and liquidation cost (including legal cost) of $20 Mio, the value of the firm may reduce by $47 Mio as below:

Liquidation Value Calculation $ Mio
Distress selling loss of inventory (20% of 1350) 27
Add liquidation cost 20
Total Reduced Realization 47

So we deduct this amount of total reduced realization from the adjusted book value which comes to

$ 3900 Mio Less $ 47 Mio = $ 3853 Mio.

Let us now look at the influence on investment decisions from an analyst’s perspective.

Liquidation Value Method Uses – An Analyst’s Perspective

Liquidation value method can be used for making investment decisions. If the company is profitable and industry is growing too, the company’s liquidation value will normally be much lower than the share price, since share price factors growth aspect which liquidation value does not.

For companies going through a decline phase or if the industry is dying, the share price may be lower than the liquidation value; this would logically mean that the company should shut business. To have arbitrage benefits, smart corporate raiders usually are on a lookout for these kinds of companies. Since the liquidation value is higher than the market share price, they can buy out the company stock at a lower price and then sell off the company to make risk-free arbitrage profit.

Limitations of Liquidation Value Method

Summing up the concept, liquidation value reflects the base price for the company. However, this may not be a very wise tool to measure a profitable company as it ignores the future growth potential. Nonetheless, this method can be considered to evaluate a dying company as a potential takeover and sell down for profit making.

For companies with proprietorship or partnership model; there may be a high dependence of profitability on the partners. It may be because of the key partners (their skill, ability, knowledge, network etc) that the business enjoys profitability; and their liquidation value may not reflect true value unless we value the impact of these key personnel on business profitability. This leads to a need to calculate the goodwill impact which is built up by the key personnel to arrive at fair liquidation value. So this model of valuation is suitable only for such special cases where liquidation is the motive. However, it is to be noted that this method is far more realistic compared to the book value method of equity valuation.

References:

http://www.iese.edu/research/pdfs/DI-0449-E.pdf

http://thismatter.com/money/stocks/valuation/book-liquidation-value-q-ratio.htm

Last updated on : June 5th, 2018

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