liquidity - 1 Marketability and Value: Measuring the...

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1 Marketability and Value: Measuring the Illiquidity Discount Aswath Damodaran Stern School of Business July 2005
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2 Marketability and Value: Measuring the Illiquidity Discount Should investors be willing to pay higher prices for more liquid assets than for otherwise similar assets that are less liquid? If the answer is yes, how much should the premium be for liquid assets? Conversely, how do we estimate the discount for illiquid assets? In this paper, we argue that it is a mistake to think of some assets as illiquid and others as liquid and that liquidity is a continuum, where some assets are more liquid than others. We then examine why liquid assets may be priced more highly than otherwise similar illiquid assets and why some investors value liquidity more than others. We follow up be presenting the empirical evidence that has accumulated over time and across different assets – financial and real – on the cost of illiquidity. Finally, we consider how we can use the theory and evidence on illiquidity to estimate the effect of illiquidity on the value of an asset or business.
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3 When you buy a stock, bond, real asset or a business, you sometimes face buyer’s remorse, where you want to reverse your decision and sell what you just bought. The cost of illiquidity is the cost of this remorse. In the case of publicly traded stock in a heavily traded company, this cost should be small. It will be larger for stock in a small, over-the- counter stock and will escalate for a private business, where there are relatively few potential buyers. It can also vary for different types of assets, with higher costs for real assets and lower costs for financial assets. In this paper, we will examine the reasons why investors value liquidity and the empirical evidence on how much they value it. We will follow up by looking at how the perceived liquidity or illiquidity of an asset affects the price you would be willing to pay for it and how best to incorporate illiquidity into valuations. Measuring Illiquidity You can sell any asset, no matter how illiquid it is perceived to be, if you are willing to accept a lower price for it. Consequently, we should not categorize assets into liquid and illiquid assets but allow for a continuum on liquidity, where all assets are illiquid but the degree of illiquidity varies across them. One way of capturing the cost of illiquidity is through transactions costs, with less liquid assets bearing higher transactions costs (as a percent of asset value) than more liquid assets. In this section, we consider the components of transactions costs for publicly traded assets first and then extend the analysis to cover non-traded assets. Transactions Costs on Publicly Traded Assets There are some investors who undoubtedly operate under the misconception that the only cost of trading is the brokerage commission that they pay when they buy or sell assets. While this might be the only cost that they pay explicitly, there are other costs that
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This note was uploaded on 12/01/2011 for the course FINANCE 350 taught by Professor Aswath during the Summer '10 term at NYU.

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liquidity - 1 Marketability and Value: Measuring the...

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