Both the theory and the empirical evidence suggest that
illiquiditymattersand thatinvestors attachalowerpriceto
assetsthataremoreilliquidthantootherwisesimilarassets
thatareliquid.Thequestionthatwefacewhenvaluingassets,
then,ishowbesttoshowthisilliquidity.Inthissection,we
considerthreealternatives.Thefirstisto valueanasset or
businessasifitwerealiquidinvestment,andthentoapplyan
illiquiditydiscounttothatvalue.Thesecondistoadjustthe
discountrateusedinadiscountedcashflowvaluationforthe
illiquidityoftheasset;moreilliquidassetswillhavehigher
discount rates. The third is through relative valuation, by
valuinganassetbasedonhowassetsofsimilarliquidityhave
beenpricedintransactions. Inthissection, weconsiderall
three.
Illiquidity Discounts on Value
Inconventionalvaluation,thereislittlescopeforshowingthe
effectofilliquidity.Thecashflowsareexpectedcashflows,
thediscountrateisusuallyreflectiveoftheriskinthecash
flowsandthepresentvalueweobtainisthevalueforaliquid
business.Withpubliclytradedfirms,wethenusethisvalue,
makingtheimplicitassumptionthatilliquidityisnotalarge
enoughproblemtofactorintovaluation.Inprivatecompany
valuations,analystshavebeenlesswilling(withgoodreason)
to make this assumption. The standard practice in many
privatecompanyvaluationsistoapplyanilliquiditydiscount
tothisvalue.Buthowlargeshouldthisdiscountbe,andhow
canwebestestimateit?Thisisaverydifficultquestionto
answerempiricallybecausethediscountinprivatecompany
valuationsitselfcannotbeobserved.Evenifwewereableto
obtain theterms of all private firm transactions, note that
whatisreportedisthepriceatwhichprivatefirmsarebought