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In financial markets, asset liquidity is a key and active consideration. Liquidity refers to the ease in which an asset can be converted into cash, with cash being fully liquid and other securities liquid, to varying degrees. Investors value liquidity and would pay more for an asset that is fully liquid than for an otherwise identical asset that is not fully liquid.
Liquidity and marketability are often confused. Liquidity risk is an aspect of the secondary market. Liquidity involves both speed of the transaction and visibility around its selling price.
Marketability, on the other hand, is linked to transaction velocity. Technology clearly though has reduced the processing cost associated with transactions as well as making it easy for private company sales through online marketplaces and private investor sites. Regardless of whether you are doing valuation based on intrinsic economic value, comparing against how similar assets are priced multiples or pricing via real options contingent claim valuation , illiquidity impacts value, both in terms of cash flow considerations and asset allocation decisions.
After all, valuation is a process used to determine what a business is worth. We assume that the demand and supply of a financial asset jointly determine the equilibrium price of the asset at any given time. The economy is represented by a single state variable say, wealth , symbolized by V. As the economy grows, the supply curve moves to the right, as does the demand curve. For example there is a difference in valuing a small family run restaurant than the hottest tech startup planning to go public.
In publicly traded equity markets, liquidity factors may be minimal and simpler, even though they still exist. How large should a liquidity discount be for any given company? This is a technical challenge given that the discount itself is not explicit. In a technical guide for the valuation profession, the Internal Revenue Service IRS recognizes the difficulty in judging the lack of marketability and state that: Obtaining valuable insight around comparable company transactions is notoriously difficult, but if such information is available, it will be the final transaction price rather than current fundamental value that is reported.
The delta between intrinsic valuation and pricing is, after all, a function of liquidity, not to mention potentially a number of other qualitative and quantitative factors that in turn help increase or decrease liquidity. In other words, liquidity can be conceptualised as impacting pricing and not necessarily intrinsic value. A further complication is that investors do not also announce their reasons for trading or buying assets.
One challenge for many business valuation reports is therefore how to effectively communicate the value of a nonmarketable equity interest, particularly the rationale for the selected discount for lack of marketability DLOM.
Although, conversely, it is also reasonably intuitive to business owners and investors that private companies typically sell at a price discount compared to otherwise comparative public companies. This is a non-optimal approach as levels of liquidity and therefore the subsequent illiquidity discounts applied should vary between markets, sectors, assets, investor profiles and even over timeframes employed.
According to Professor Damodaran, there are macro factors that impact liquidity, as outlined below. Liquidity of assets owned by the firm. The fact that a private firm is difficult to sell may be rendered moot if its assets are liquid and can be sold with no significant loss in value.
A private firm with significant holdings of cash and marketable securities should have a lower illiquidity discount than one with factories or other assets for which there are relatively few buyers. Financial health and cash flows of the firm. A private firm that is financially healthy should be easier to sell than one that is not healthy.
In particular, a firm with strong income and positive cash flows should be subject to a smaller illiquidity discount than one with negative income and cash flows. Possibility of going public in the future. The greater the likelihood that a private firm can go public in the future, the lower should be the illiquidity discount attached to its value. In effect, the probability of going public is built into the valuation of the private firm.
Think internet companies going public during the dotcom boom. Size of the firm. If we state the illiquidity discount as a percent of the value of the firm, it should become smaller as the size of the firm increases. Operating history, business models and control controlling block of shares should also be considered.
The key issue at hand is how we can integrate liquidity factors into valuations. For DCF valuations there are two key approaches: The most common method is based on analysis of restricted stock which are pre-IPO transactions with lock-down periods for example, rule stipulates six months for public equity and by looking at discounts of different stock classes traded in different markets with different liquidity profiles and also bid-spread margins of public stocks, basically the ease with which you can sell a security and immediately recover your capital.
Professor Damodaran sums up these studies. First, Maher examined restricted stock purchases made by four mutual funds in the period and concluded that they traded an average discount of Second, Moroney reported a mean discount of 35 percent for acquisitions of restricted stock issues by 10 investment companies, using data from Third, Silber examined restricted stock issues from to and found that the median discount for restricted stock is Finally, other studies confirm these findings of a substantial discount, with discounts ranging from percent.
One recent study by Johnson did find a smaller discount of 20 percent. The second main approach is via direct adjustments in cost of capital calculations, for instance, a build-up approach to CAPM. At the most simple level we look at the return profile of our asset class for instance, small-caps against the broader market or look in a bit more detail against a basket of factors, such as turnover ratio, trading volume and the aforementioned bid-ask spread. For relative valuation, we can either apply a fixed discount to the multiple or final economic value estimate or, where possible, filter the comparative universe not only on sector and risk and return characteristics but also liquidity variables such as high floats, trading volumes and low bid-ask prices.
A report by NERA looked at how the equity risk premium could be used to quantify a potential liquidity discount. An interesting study by KPMG looked at the more specific question of the marketability discount of controlling blocks of shares. MD1 is the marketability discount in percentage terms that can be applied to the value of a firm derived from a standard discounted cash flow analysis, or any similar valuation method, which are known to omit the illiquidity of the controlling block.
MD1 is the appropriate discount in the case of shares of privately held corporations where a share price is unobservable. MD2 is the marketability discount in percentage terms that can be applied to the price of the shares traded in an active market. MD2 is appropriate for the case of public corporations. Therefore, the total value of the block under MD1 is: The periods of high marketability discount appear to correlate well with the periods where the term structure of interest rates had a negative or low slope.
They also suggest that there appears to be a role for industry and firm-level variables. In all cases, lower liquidity should affect asset pricing. However, the liquidity needs of both the seller and the buyer should also be factored into appraisal analysis and investment decisions. The concept of illiquidity is, therefore, an essential consideration for valuation professionals — and business owners — who value assets that do not have readily-available market quotations to draw upon.
This is an expanded version of the article which appeared in the September issue of Financier Worldwide: Investors are generally willing to pay higher prices for more liquid assets than for otherwise similar illiquid assets.