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.
