Not long ago we saw on the blogThe 4 most used asset valuation methods in value investing, which are usually the first step in the valuation process when analyzing companies in which to invest. On this occasion, I bring you a fifth method, which is used only in the case of companies that are going to cease their activity and be dissolved, returning their assets to their shareholders. In this article I will explain what the Liquidation Value is and how it is calculated with practical examples.
What is the Liquidation Value of a company?
The Liquidation Value of a company (“Liquidation Value” in English) is the value that would be obtained by that company in the event that it ceased its activity, sold its assets, settled its debts and distributed the money among its shareholders.
Calculation of the Settlement Value
For the calculation of the Liquidation Value of a company we must subtract the expenses incurred by the liquidation of the company from the market value of its assets once its debts have been paid.
NAV = Market Value of Assets - Total Debt - Settlement Expenses
Among the liquidation expenses, we must take into account the following:
- Attorney and litigation expenses
- Workers' compensation for dismissal
- Tax expenses
- Other settlement costs
One problem that we must face when calculating the Liquidation Value is that the liquidation expenses are not usually known in advance, and may vary due to various circumstances. Therefore, it is advisable to combine the calculation of the liquidation value with a scenario analysis to avoid unpleasant surprises in the future.
Liquidation value calculation example
Suppose a company is going to be liquidated. We calculate that the market value of its assets is 10 million euros and that its debts amount to 5 million.
We estimate that the settlement costs will be between 500.000 and 1 million euros, depending on whether the settlement is complicated or not, which is something that usually happens in about half of the cases.
In this case, we must perform a scenario analysis, since the Liquidation Value will depend on whether the liquidation is complicated or not.
Scenario A: Settlement is not complicated
VL = 10.000.000 – 5.000.000 – 500.000 = 4.500.000 €
Scenario B: Settlement gets complicated
VL = 10.000.000 – 5.000.000 – 1.000.000 = 4.000.000 €
Taking into account that we give a 50% probability to each scenario, the expected Liquidation Value will be:
VL = 4.500.000*50% + 4.000.000*50% = 4.250.000 €
When is the Liquidation Value used when investing in the stock market?
This method is used to obtain the value of a company that can be liquidated, so its usefulness is limited to very specific cases.
The Liquidation Value also helps us to establish a minimum value of a company so that, in the event that things go wrong, obtain an approximate estimate of the money that we could receive in the event that the company goes bankrupt and goes into liquidation.
Personally, I do not advise you to invest in companies at risk of bankruptcy and liquidation. It is true that many investors sometimes find real bargains, but it must also be borne in mind that the risk they take is very high and that they can spend hundreds of hours analyzing a single company.
Of course, as I always say, the final decision is in your hands. 😉