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Value of Liquidity

Once a firm has been valued, should there be a discount for illiquidity if the stake in the firm, whether it takes the form of publicly traded shares or a partnership, cannot be easily sold? Illiquidity falls in a continuum, and even publicly traded firms vary in terms of how liquid their holdings are. The illiquidity discount tends to be most significant when private businesses are up for sale. In practice, the estimation of liquidity discounts seems arbitrary, with discounts of 25% to 30% being most commonly used in practice.

Determinants of Illiquidity Discount

The illiquidity discount should vary from firm to firm and should depend on the following factors:

  • Size of the business: As a percent of value, the discount should be smaller for larger firms; a 30% discount may be reasonable for a million-dollar firm, but not for a billion-dollar firm.

  • Type of assets owned by the firm: Firms with more liquid assets should be assigned lower liquidity discounts, since assets can be sold to raise cash. Thus, the discount should be lower for a private business with real estate and marketable securities as assets than for one with factories and equipment.

  • Health and cash flows of the business: Stable businesses that generate large annual cash flows should see their value discounted less than high-growth businesses where operating cash flows are either low or negative.

Quantifying the Liquidity Discount

There are two ways of quantifying the liquidity discount. One way is to use the results of studies that have looked at restricted stock. Restricted securities are securities issued by a company, but not registered with the SEC, that can be sold through private placements to investors. These securities cannot be sold for a two-year holding period, and limited amounts can be sold after that. These restricted stocks trade at discounts ranging from 25% to 40%, because they cannot be traded. Silber, in 1991, related the discount to observable characteristics of the firms issuing the stock:

Ln(Price of Restricted Stock ÷ Price of Unrestricted Stock) = 
4.33 + 0.036 Ln(Revenues) 
– 0.142 (Restricted Block as a Percent of Total Stock Outstanding) 
+ 0.174 (DERN) + 0.332 (DCUST)

where DERN = 1 if earnings were positive and zero if not, and DCUST = 1 if the investor with whom the stock was placed had a customer relationship with the firm and 0 if not.

The other, and potentially more promising, route is to extend the research on the magnitude of the bid-ask spread. Note that the spread, which measures the difference between the price at which one can buy a stock or sell it in an instant, is a measure of the liquidity discount for publicly traded stocks. Studies of the spread have noted that it tends to be larger for smaller, more volatile, and lower-priced stocks. You could look at private firms as very small, nontraded stocks and estimate a "spread" which would also be the liquidity discount.

While you would expect the illiquidity discounts to be larger at privately owned technology firms, the discounts will be tempered by the option that these firms have to go to the market. In 1999 and early 2000, for instance, when investors were attaching huge market values to Internet-based firms, investors in privately held online ventures may have been willing to settle for little or no discount because of this potential.

Liquidity Discounts at Publicly Traded Firms

Some publicly traded stocks are lightly traded, and the number of shares available for trade (often referred to as the float) is small relative to the total number of shares outstanding.11 Investors who want to quickly sell their stock in these companies often have a price impact when they sell, and the impact will increase with the size of the holding.

Investors with longer time horizons and a lesser need to quickly convert their holdings into cash have a smaller problem associated with illiquidity than do investors with shorter time horizons and a greater need for cash. Investors should consider the possibility that they will need to convert their holdings into cash quickly when they look at lightly traded stocks as potential investments and should therefore require much larger discounts on value before they take large positions. Assume, for instance, that an investor is looking at Red-iff. com, a stock that was valued at $19.05 per share. The stock would be underpriced if it were trading at $17, but it might not be underpriced enough for a short-term investor to take a large position in it. In contrast, a long-term investor may find the stock an attractive buy at that price.

ILLUSTRATION 7.6

Float and Bid-Ask Spreads

In Table 7.9, the trading volume, float, and bid-ask spreads are reported for Amazon, Ariba, Cisco, Motorola, and Rediff.com.

Although the bid-ask spreads are between 1/16 and 1/8 for all of the firms, the spread is a much larger percentage of the stock price for Rediff, which is trading at about $10 per share, than it is for Cisco or Ariba. In addition, only about 20% of the shares outstanding are available for trading at Rediff and only about a third of the shares at Amazon are traded.

TABLE 7.9 Liquidity Measures: Amazon, Ariba, Cisco, Motorola, and Rediff

 

Amazon

Ariba

Cisco

Motorola

Rediff

Number of shares

351.77

235.80

6,890.00

2,152.00

24.90

Trading volume

8.22

6.19

42.87

14.1

NA

Float

138.80

134.70

6880.00

1940.00

4.60

Bid-ask spread

$0.0625

$0.1250

$0.0625

$0.0625

$0.125


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