Podcast Transcript

Welcome to Part B of the two part episode on Valuation Methods. In part A we ran through how to value a business using the Discounted Cash Flow model. This method can be used to value the majority of businesses, especially those that are expected to continue operating well into the future. Today we will take a look at the Liquidation Value of a business. Liquidation Value can be used to estimate the potential investment risk of holding a company, as it provides you with an estimated value you, as an investor, can expect to receive if the company was to go out of business and its assets liquidated. Given shareholders are the last to be paid in the event of a liquidation, it is often the case that they will not receive any compensation for their investment in the business, resulting in a 100% loss. If however the Liquidation Value of the business is say $100 for example and you paid $200 for the business, then you can at least hope to get back $0.50 on each dollar you invested, or in other words a 50% loss total, which is obviously much better than a 100% loss.

The Liquidation Value is a method Benjamin Graham developed to estimate a value for the assets of a business if it was to be liquidated. It is basically the Tangible Book Value of a business but adjusted to better represent the liquidation value of its assets. When a business is trading near its Liquidation Value, it obviously has some problems. It would be amiss of someone to expect a struggling business to be able to sell its assets and inventory at Book Value, or the value quoted on the company’s Balance Sheet. This inability for a company to sell its assets at Book Value could be due to the company’s products not being as desirable or in such high demand as it used to, or the industry in which the business operates becoming obsolete. Unless you have the ability to analyse each asset and individually estimate the current market value of the assets, you can instead refer to estimates of the recovery rates for each asset class as determined by Benjamin Graham in his extensive research.

The recovery rates are as follows:

Here is a breakdown of each asset class:

Cash Assets – These are assets which include cash, government and other high-grade bonds and marketable securities. These are highly liquid assets that can be bought and sold at face value.

Receivables – Assets which include moneys owed to the business (debtors). We can expect a high recovery rate from these items as customers can be held accountable for what is owed.

Inventory – Assets which include products or raw materials for sale (trading stock). Inventories can bring a lower recovery rate as growing inventories are often a precursor to the liquidation. If the products being sold were still in high demand, then chances are the company would still be in business and not facing liquidation.

Fixed Assets – Assets which include plant, property and equipment. Often the plant and equipment are specialised to cater for that particular product or business and therefore if that product has become unfashionable or obsolete and the industry as a whole is struggling, then so too the business would struggle to sell its fixed assets at Book Value.

To apply this valuation method, we now simply look at the Balance Sheet and calculate the Liquidation Value of each asset by multiplying them by the recovery rate. For example, say a bike store was facing liquidation and on its Balance Sheet it had Assets to the value of; $1,000 in cash, $1,000 in receivables, which mainly consists of moneys owed by customers who purchased bikes on credit, $2,500 worth of bikes held as Inventory, and the store fit out which is recorded as a fixed asset under Property, Plant and Equipment is valued at $1,500. Now we will run through the different Assets and apply the Median Recovery Rate as suggested by Benjamin Graham.

Cash Assets of $1,000 will see a 100% recovery so this Asset is valued at $1,000.

The $1,000 in Receivables will likely see an 80% recovery, so $1,000 multiplied by 80% is equal to $800.

We expect to receive 60% of the value of the bikes remaining in Inventory as the store is having a closing down sale with everything 40% off. So, the Liquidation Value of Inventory is; $2,500 multiplied by 60% which gives us $1,500 worth of Inventory.

Lastly we had the Fixed Assets of Property, Plant and Equipment which consisted of store fit out. The Book Value of these Assets was $1,500. We can expect to receive at least 15% of the remaining value for these Assets. So this is equal to $1,500 multiplied by 15%, which gives us $225 worth of Fixed Assets.

The sum of all the Assets at Liquidation Value is as follows; $1,000 for the cash, plus $800 for the Receivables, plus $1,500 worth of Inventory and $225 in Fixed Assets, totalling $3,525. The business also had a few outstanding Liabilities which included; $500 in Accounts Payable to its bicycle supplier and $1,000 of outstanding Bank Loans. Given these Liabilities must be paid first before the shareholder in the event of a Liquidation, we must subtract the sum of $1,500 in Liabilities from the Liquidation Value of Assets which was $3,525, leaving us with $2,025 remaining for distribution amongst shareholders. It is very important not to forget to deduct the Liabilities of a business as these accounts are required to be settled before any remaining business value is distributed to shareholders.

So in summary, as an investor, we have calculated how much a company is expected to be worth if it was to go out of business and be liquidated, this is known as the Liquidation Value. This valuation can be used if you are looking to buy severely undervalued businesses which are likely to be liquidated. In some cases you may find a business trading below its Liquidation Value which would present an investor with a relatively low risk investment, but one must be cautious of timing, as if the business was to linger on and continue operating, you could find yourself with an investment in a business that is quickly burning through cash and thus resulting in the Liquidation Value of the business slowly diminishing. This scenario could also result in very little liquidity, meaning you may be left with a heap of shares that you are unable to sell. So, for this reason it is important to be aware of the risk of timing and investing into an under performing business that continues to operate, slowly eroding away any remaining value within the business.

Another use for the Liquidation Value is to give an investor an idea of how conservative management is and also provide an expected return if the company was to go out of business. You will often find businesses that have a negative Liquidation Value, which indicates that the business has more Liabilities than the Liquidation Value of its Assets. In this scenario an investor faces the possibility of a 100% loss of their invested money in the event of a liquidation.

I hope now you better understand the importance of knowing the Liquidation Value of a business and how to apply it when making an investment. Also, from Part A of this episode on calculating the value of a business using the Discounted Cash Flow model, you will be able to reduce the chances of overpaying for an investment which can result in the under performance of your investment returns.

Thanks for listening in.