Question

I need detailed long answer, more than 1 page, with references.

True/ False - The liquidation value of a company's shares always places a floor under its stock price

Answer 1

In theory, yes the liquidation value of a company's shares places a floor under its stock price

Liquidation value is defined as the total value of the companies assets assuming the company is shutting down or going out of business. The company will pay off all its liabilities with the assets it has sold and the rest would be distributed to the equity owners. Generally intangible assets are not included while calculating the liquidation value as the company is not continuing as a going concern and intangibles will have no value to sell in this case of liquidation.

Generally the liquidation value of a company is lower than the initial market value of the firm before liquidation stage and sometimes even lower than the book value. Market value is the current price the market would be willing to pay to acquire the asset, while book value is the historical price at which the asset was acquired.

Generally market value is composed of the book value of the asset and the future growth which the asset would be able to generate. Hence for a going concern, the market expects that the company with its assets will be able to generate growth going forward and hence the market will be generally greater than its book value

But when a firm is going for liquidation, it means that the firm is facing many issues and sees no growth/future for the firm going forward. Hence there is no future growth prospect to the market value in case of liquidation. Hence the market value goes down and will be equal to the the liquidation value, which will be lower than the actual initial market value. Also when the firm is going for liquidation, the firm's assets will be quickly losing its value and since others know this, they will try to bargain and acquire the asset at the lowest possible rate. Hence this sometimes makes the assets go below their book value also.

Hence, if a firm's assets goes well below the book value, there should be a floor for the selling price of the assets and therefore there will be a floor to its stock price. Also if there is no floor for the stock price, then there would be no point in going for liquidation also, as the costs of liquidation will not be able to cover even the price of stock, leave alone the gains from liquidation. The floor price is also helpful in prevention of earning a risk less profit [when the stock price falls very low, then some investor can buy majority of the stock, then liquidates the assets and hence stock price is very low than liquidation of assets, he can earn a risk less profit]