Posts in category: Business

When it comes to valuing a business, there are many ways to examine a company’s profitability. Looking at a business’ liquidation value and its breakup value are two of many approaches to see how a company is functioning and how it might run under different management and economic environments.

Liquidation Value

This type of valuation can be defined as the difference between what tangible assets would sell for at auction minus outstanding liabilities. Typically, intangible assets are not considered in this type of valuation. However, if the intangibles along with the physical assets are considered for sale and not sold at auction, it would be considered a business’ “going-concern value.” Examples of intangibles include goodwill, brand recognition, patents, etc.

There are many considerations when exploring liquidation value. Generally speaking, the liquidation value is more than salvage value but less than book value. When a company is going out of business and assets are auctioned off, proceeds will normally be valued below the asset’s historical cost. Historical cost refers to how assets are reported on the balance sheet. However, if the market assesses assets lower in value compared to business use, it could be lower than book value.

Here is an example of how liquidation value can be calculated. Say a business has liabilities of $1.1 million. Based on the balance sheet, the book (or historical) value of assets is $2 million; and assets have a salvage value of $100,000. If the value of selling the business’ assets via auction is projected to be $0.80 per dollar, it could be expressed as follows:

$1.6 million (assets sold at auction at $0.80 per dollar) – $1.1 million (liabilities) = $500,000 (Liquidation Value)

Breakup Value

Also known as “the sum-of-parts value,” the breakup value determines the worth of a corporation’s individual segments if they were operating independently. Investors might pressure the company to spin off one or more segments into a separate publicly traded company to maximize its value.  

For each operating unit, the first step involves determining the segment’s cash flow, revenue and earnings. Such valuations can be benchmarked to publicly traded industry peers to determine comparative value of the business segment in question.

Financial ratios, including price-to-earnings (P/E) or price to free cash flow, are examples of starting points that analysts use to compare segmented business lines to industry peers to determine if it’s trading at below fair value, fair value or above fair value.

For example, if the P/E ratio of the company being analyzed is lower than its peers, it could mean the company is cheaper, or trading below fair value on an earnings basis. Though a more thorough financial analysis and assessment of macroeconomics is recommended, such as interest rates, inflation, etc., analysts could make an educated projection on how future earnings may or may not hold up in the future, compared to the business segment’s snapshot valuation.

Another way to evaluate is via discounted cash flows (DCF). This shows the segment’s future free cash flow projections through a discount rate, generally the weighted average cost of capital (WACC). The formula arrives at the present value of the business segment’s future cash flows. The following DCF example can tell the expected profitability and how to treat it going forward as part of the business:

Assume the company’s WACC is 10 percent; the amount invested is $5 million; it will last three years; and the annual estimated cash flows are as follows:

Cash Flow                           Discounted Cash Flow

Year 1: $2 million             $1,818,181.82

Year 2: $4 million             $3,305,785.12

Year 3: $6 million             $4,507,888.81

Compared to the amount invested of $5 million for the business’ selected business segment, the discounted cash flows for the project are $9,631.855.75. This could give an indication of how the business line might do if it’s spun off or how its performance will impact other lines of the business financially.

While valuation is subjective, especially in periods of volatile inflation and interest rate conditions, the more points of valuation analysis that occur, the better the chances that valuations will turn out to be correct.

By 2021, there were 20,000 warehouses in the United States and growing, according to the United States Bureau of Labor Statistics (BLS). With more warehouses expected to pop up in 2022 and beyond, one important consideration for businesses of all sizes is to keep track of their inventories. With different tracking and valuation methods, it’s important to understand how they work and what they can tell business owners.

Before inventory can be valued, it’s imperative to understand how it can be expressed mathematically:

Ending Inventory = Starting Inventory + Net Acquisitions – Cost of Goods Sold (COGS)

Now that inventory is better defined, understanding different approaches to inventory valuation are essential to keeping track. The first type of inventory valuation is referred to as FIFO or First In, First Out. This means that businesses sell their earliest produced inventory first and new inventory last.

Assume a company produces 500 widgets on day 1, costing $2 per widget. The same company then produces 500 widgets on day 2, costing $2.50 per widget. This method says that if 500 widgets are sold over the next week, the cost of goods sold (COGS), derived from the Income Statement, is $2 per widget because that’s how much the first 500 widgets cost to produce for inventory. The remaining widgets, 500 widgets at a cost of $2.50 per unit, would be accounted for under the ending inventory on the balance sheet.

One consideration, especially in an inflationary environment, for remaining inventory on the balance sheet is that a business might see a higher tax obligation. This is likely to occur because of higher net income due to a lower cost basis from the older inventory when assessing the COGS. Newer, more expensive inventory will naturally lead to a lower tax basis, especially if inflation falls and the retail cost is mitigated by decreased demand.

The next option is referred to as LIFO – or Last In, First Out. This means that businesses sell what they’ve produced first, then move on to the older inventory. If any inventory is left at the end of the accounting time frame, it’s accounted for accordingly. Assuming the same 500 widgets were sold in the particular accounting period, the time frame’s COGS would be $2.50 per widget, with the 500 widgets left over in inventory valued at the $2 per widget cost. 

One important caveat to this type of valuation concerns inventory that’s perishable or becomes obsolete quickly (cell phones, televisions, etc.). It is not an effective method because the product will either spoil or become worth next to nothing due to highly competitive industries. For this approach, using the most recently produced goods first would lend their COGS basis to be higher. In one respect, the higher COGS basis can lower profits, but can also offset taxes due to the same effect. The third type of inventory valuation is referred to as Average Cost. This method is a way to blend LIFO and FIFO, which takes the average of inventory across all production and storage timelines. This approach averages costs in proportion to the number of widgets produced in each run, then calculates the mean cost to determine the ending inventory and COGS figures.

Therefore, the average cost for inventory using this method would be $2.25 per widget.

With different types of inventory valuation explained, there are considerations that businesses should be mindful of for each approach. This can make a difference to those running the company and potential investors and lenders contemplating investing in or loaning the company money.