With the notable exception of firms in seriously declining industries or in high distress, businesses are normally worth more alive (i.e., as going concerns) than dead (i.e., liquidated).

As a result, “liquidation value” (i.e., the estimated proceeds the firm’s owners could get out of a disposal of its assets, after paying off its liabilities), is often considered as a floor in valuation, and companies selling below their liquidation value are typical hunting grounds for bargains.

The most logical starting point to estimate liquidation value would be (tangible) book value, but experience (otherwise known as the “School of Hard Knocks”) has taught investors (most notably Warren Buffett after investing in textile mills) that assets in an unfavorably situated industry often sell for much less than their net book value in a liquidation scenario.

So how can one estimate the “base rate” for liquidation value?

Below is a review of the existing literature on the subject:

Value investing literature

Graham & Dodd

Benjamin Graham and David Dodd, in the 1940 edition of their classic Security Analysis, point out, in estimating liquidation value, that all true liabilities shown on the books must be deducted at their face amount, but that the value of the assets must be questioned.

They then provide the following rough estimates of liquidation values for different types of assets, as a percentage of book value:

• Cash assets (including securities at market): 100% of book value.
• Retail installment accounts: 30-60% (50% on average).
• Other receivables (less usual reserves): 75-90% (80% on average).
• Inventories (at lower of cost or market): 50-75% (67% on average).
• Fixed assets: 1-50% (15% on average).

Seth Klarman

Seth Klarman, in his out-of-print book Margin of Safety, published in 1992, provides the following guidance on recovery rates in liquidation:

• Cash: 100% of book value.
• Investment securities: Market prices, less estimated transaction costs.
• Accounts receivable: Close to their face amount.
• Inventories: The realizable value of inventories may well be less than book value. The discount depends on whether the inventories consist of finished goods, work in progress, or raw materials, and whether or not there is a risk of technological or fashion obsolescence.
• Fixed assets: The liquidation value of fixed assets can be difficult to determine. The value of plant and equipment depends on its ability to generate cash flows, either in the current use or in alternative uses. Some machines and facilities are multipurpose and widely owned; others may have value only to the present owner.

In his contribution to the 7th edition of Security Analysis, published in 2023, Klarman adds the following words of caution:

(…) liquidation value has become increasingly murky. Companies are not easily or frequently liquidated; all liabilities, including off–balance sheet and contingent ones, must be extinguished before liquidation proceeds are distributed to shareholders, whose interests are subordinated. Rent must be paid under leases that may extend well into the future. Employees may have been promised deferred compensation or termination benefits. Products may have extended warranties. Underfunded pension plans must be funded. Also, many companies that seem potentially discounted based on balance sheet analysis have a cash burn rate until the time that they achieve a future profitability.

Bruce Greenwald et al

In the second edition of their book Value Investing: From Graham to Buffett and Beyond, published in 2020, authors Bruce Greenwald, Judd Kahn, Paul Sonkin, and Michael Van Biema provide the following guidance on recovery rates in liquidation:

• Cash and marketable securities: No discount to book value, provided the securities are short-term or have been marked to market. In a generic case, the authors suggest using 100% of book value.
• Accounts receivable: These will probably not be recovered in full. In a generic case, the authors suggest using 85% of book value.
• Inventory: The more commodity-like the inventory, the lower the discount. If the inventory consists of unsalable items, it may be necessary to pay someone to dispose it. In a generic case, the authors suggest using 50% of book value.
• PP&E: Generic assets such as office buildings will be worth far more relative to book value than specialized structures such as chemical plants. In a generic case, the authors suggest using 45% of book value.
• Goodwill: In a nonviable industry, highly specialized assets such as product lines, customers, trained workforce, which underly goodwill are not likely to have significant value. In a generic case, the authors suggest using 0% of book value.

Distressed investing literature

Whitman & Diz

In their book Distress Investing: Principles and Techniques, published in 2009, authors Martin Whitman and Fernando Diz provide the liquidation analysis performed for the Chapter 11 reorganization of Home Products International in 2007.

The table illustrates (1) that most assets (aside from land & buildings) would likely fetch less than their book value in liquidation (e.g., 75% for machinery & equipment, 60% for receivables, 41% for inventory, 0% for goodwill), and (2) examples of deductions that need to be made to get to the net amount available for shareholders (in this case a negative amount), namely:

• Liquidation costs.
• Real estate holding costs.
• Secured debt.
• Priority tax claims.
• Secured employee claims.
• Unsecured note holders.
• Other liabilities.

Schultze

In his book The Art of Vulture Investing: Adventures in Distressed Securities Management, published in 2012, author George Schultze provides the liquidation analysis performed for Chrysler Automotive in 2009.

The table shows (1) the wide uncertainty related to liquidation value estimates, materialized by the computation of three alternative recovery scenarios (low, expected, high) which would give a total available for bank lenders as a % of face value between 47% and 140%, (2) that apart from unrestricted cash (100%) and marketable securities  (95-105%), all other types of assets would be expected to be sold for less than book value (e.g., 75-80% for restricted cash, 65-80% for accounts receivable, 45-60% for inventories, 35-60% for equipment on operating leases, 10-35% for prepaid expenses, 10-30% for PP&E, 10-50% for short-term and 5-35% for long-term deferred taxes, 0-15% for goodwill and intangibles), and (3) the types of deductions to be made to arrive at the net available for bank lenders, namely corporate windup costs (estimated at 5% of liquidation assets) and cash burn during liquidation.

Altman, Hotchkiss, and Wang

In the 4th edition of their book Corporate Financial Distress, Restructuring, and Bankruptcy, published in 2019, authors Edward Altman, Edith Hotchkiss, and Wei Wang detail the typical process that companies seeking to reorganize under Chapter 11 must go through:

“Each asset on the balance sheet is assigned an estimate of the proceeds that would be received in a hypothetical conversion to Chapter 7. The amounts that can be recovered, net of fees and expenses, are available for distribution in priority order to the firm’s claimants. Liquidation would result in additional costs including the compensation of a bankruptcy trustee to oversee the process, legal and other professional fees, asset disposition expenses, litigation costs, and claims arising from the operations of the debtor while the case is pending. Liquidation value will be low if asset specificity is high (i.e., value is low in any use other than the current one) or the secondary market for assets is thin.”

Other sources

Most textbooks and academic papers do not give precise guidance or statistics on actual asset recovery rates in liquidation.

Authors however point to parameters which may have an impact on liquidation value:

• Timeframe and context of liquidation: orderly or distressed (“fire sale”).
• Ability of the market to absorb the assets: If many companies are in distress and looking for buyers at the same time, this is likely to weigh down on proceeds.
• Status of the industry: If the industry is undergoing an irreversible decline, capital goods specifically tailored to the industry will be sold for scrap.
• Separability and marketability of assets.
• Transaction costs: These tend to be higher for unique assets (e.g., 15-20% for art collections) or less liquid assets (e.g., 5-6% for housing real estate) than for commodities (e.g., minimal for gold, silver and oil).
• Method of sale: Via tender, auction, or agents.
• Taxes.
• Losses and time value of money if liquidation takes a long time.

Chapter 11 appraisals

In two companion papers published in 2020, Amir Kermani (UC Berkeley‘s Haas School of Business) and Yueran Ma (University of Chicago’s Booth School Business) collected data on the liquidation analyses provided by appraisers in 387 non-financial firms‘ Chapter 11 filings over 2000-2016 (similar to the Home Products International or Chrysler examples above).

Based on this data, they compute the following liquidation recovery rates (i.e., liquidation value as a fraction of net book value) per type of asset and industry: 

• Receivables: 37-89% (63% on average). Recovery rates are highest for utilities (90%), medical and optical devices (89%), and coal (79%), and lowest for airlines (37%) and educational services (37%).
• Inventories: 15-90% (44% on average). Recovery rates are highest for auto dealers (90%), apparel stores (75%), and supermarkets (75%), given the generic nature of their inventory. They are lowest for restaurants (15%) as their inventory primarily consists of highly perishable fresh food, special construction (20%), and communications (26%).
• PP&E: 8-69% (35% on average). Recovery rates are highest for transportation (69%), lumber (58%) and wholesale (57%), and lowest for personal services (8%) and educational services (15%).

The authors find that:

• Receivables may not have full liquidation recovery rates because of (1) difficulty to enforce (foreign receivables, government receivables, receivables from concentrated large customers) or (2) offsets by payables to the same counterparties.
• Recovery rates tend to be higher for assets that are mobile, durable (low depreciation rate), and standard: (1) Mobile assets (e.g., aircraft, ships, vehicles) can reach alternative users easily, contrary to location-specific (e.g., buildings) or difficult to transport (e.g., nuclear fuel) assets; (2) Assets that depreciate faster (e.g., fresh food) are less valuable by the time they reach alternative users; (3) Standardized assets (e.g., railroad cars, trucks) can find buyers more easily than customized assets (e.g., eyeglasses for individuals, optical lenses for industrial production).
• The PP&E recovery rates above are in line with those seen in (1) actual Chapter 7 liquidations, and (2) lenders’ benchmarks (20-30% for industrial PP&E).
• Macroeconomic and industry conditions have a relatively weak impact on liquidation recovery rates on average, but a stronger impact for assets that are relatively standardized and used economy-wide or industry-wide (as opposed to customized and firm-specific).

Conclusion

For the purposes of estimating liquidation value:

• Assets should be taken at a fraction of their net book value.
• A review of the literature would suggest the following base rates:
  • Unrestricted cash: 100% of book value.
  • Marketable securities: 100% of market value.
  • Restricted cash: [75]% of book value.
  • Receivables: [60%] of book value.
  • Inventories: [40%] of book value.
  • PP&E: [30%] of book value.
  • Prepaid expenses: [20%] of book value.
  • Deferred taxes: [20%] of book value.
  • Goodwill and intangibles: [0%] of book value.
• These base rates should be adjusted for the following factors:
  • Higher recovery rates for assets that (1) are mobile, (2) are durable, (3) are standard or multi-purpose, and (4) have a wide secondary market.
  • Lower recovery rates for assets that (1) are difficult to transport, (2) are industry-specific, (3) depreciate fast, are perishable, or subject to obsolescence or fashion trends, (4) are customized, (5) are work in progress, (6) have a thin secondary market, or (7) face a strong selling pressure due to industry-wide distress.
  • Lower recovery rates for receivables from customers that are (1) foreign, (2) governmental, (3) very large or (4) very small (retail).
• Liquidation value should also factor the following deductions:
  • Liquidation costs: [5%] of liquidation assets.
  • Taxes and time value of money on liquidation assets.
  • Cash burn during liquidation: [12 months] of cash burn.
  • Secured debt.
  • Priority tax claims.
  • Secured employee claims, including compensation & termination costs.
  • Underfunded pension plans.
  • Unsecured note holders.
  • Lease obligations under rental contracts.
  • Off balance sheet or contingent liabilities stemming from product defects, environmental damage, ongoing litigation.
  • Other unsecured liabilities.

Bibliography

For further reference:

• Security Analysis, Graham & Dodd, 1940 edition
• Security Analysis, Graham & Dodd, edited by Klarman, 7th edition, 2023
• Value Investing: From Graham to Buffett and Beyond, Greenwald, Kahn, Sonkin, Van Biema, 2nd edition, 2020
• Distress Investing: Principles and Techniques, Whitman & Diz, 2009
• The Art of Vulture Investing: Adventures in Distressed Securities Management, Schultze, 2012
• Corporate Financial Distress, Restructuring, and Bankruptcy, Altman, Hotchkiss, Wang, 4th edition, 2019
• Damodaran on Valuation, Damodaran, 2nd edition
• The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses, Damodaran, 3rd edition, 2018
• Valuation: measuring and managing the value of companies, McKinsey & Company, 7th edition
• Voluntary liquidation: when is it financially profitable? Wnuczak, 2018
• Fundamentals of the liquidation method of business valuation, Poborsky, 2015
• Asset Specificity of Non-Financial Firms, Kermani and Ma, 2000
• Two Tales of Debt, Kermani and Ma, 2000