Liquidating the Balance Sheet

As mentioned in my basics course on value investing, the first step I take in valuing a company is discovering its net asset value. That is, the value per share of the company’s assets after accounting for (subtracting) all liabilities. If the company is healthy, and operates in a viable industry, the assets should be marked to their replacement value. These assets need to be replenished as they are used and any competitor wanting to enter the industry would need to pay fair market value in order to acquire similar assets. This replacement value is the normal case and would then be followed by an analysis of earnings power value, as discussed on this site previously.

What if the company is in trouble? Perhaps the company is in imminent threat of default and is not expected to continue normal operations into the future. Earnings power analysis is then useless as we can expect the company to liquidate its assets in order to pay debtors, with holders of common equity receiving the leftovers. In this case the assets of the company should be valued at liquidation value. We assume all assets are to be sold off to the highest bidder. Liabilities are then subtracted from the value of these assets to find what would remain for the holders of common equity.

As value investors, we don’t only consider companies that have long-term holding potential. Value investing is about buying an asset for less than it is worth. In some instances this may involve purchasing a company facing bankruptcy if the investor has conviction that the assets will be worth more to the common equity holder after liquidation than they can currently be purchased for, always including an appropriate margin of safety.

Valuing assets at liquidation requires a great deal of expertise and may require the services of an expert valuator. Keeping some things in mind, however, should assist you in arriving at a reasonable estimate when needed.

• Asset liquidity. The more liquid the assets are, the more likely they are to be sold at book value. For instance, cash is always valued at book value even in the case of liquidation. Marketable securities are another example of a highly liquid asset.

• Failing business vs failed industry. If the business being liquidated operates within a thriving industry then you can expect that there may be competitors willing to purchase the assets. In the case of a non-viable industry however, assets on the balance sheet are more likely to be sold at scrap prices.

• Asset specialization/customization. The pool of potential buyers shrinks the more specialized or customized the asset being sold. A warehouse that is just a stock space for storing items will have many potential buyers and will likely be sold at close to fair value (given a decent real estate market and enough time to sell). On the other hand, a warehouse that has been custom built and designed to house specific types of goods needing special care will likely be sold at far below replacement or fair value in the case of liquidation. It is important to keep industry conditions in mind though as even in the case of very specialized assets on the balance sheet, these assets could have a fair chance at being purchased closer to their replacement value if the industry is viable. In the case of a thriving industry, competitors will likely be bidding to purchase the asset in order to acquire the extra capacity on the market.

While valuing balance sheet assets at liquidation value can be a difficult task, keeping the above concepts in mind should assist you in arriving at a realistic estimate of their value. Best of luck, and as always I will do my best to respond promptly to questions and/or comments posted below.