Theotherapproachtodealingwithilliquidityistoadjustthe
discount rate used in discounted cash flow valuation for
illiquidity. In practical terms, this amounts to adding an
illiquiditypremiumtothediscountrateandderivingalower
valuefor thesamesetof expectedcashflows. Earlier,we
presented asset pricing models that attempt to incorporate
illiquidityrisk,buttheyarenotspecificabouthowweshould
goaboutestimatingtheadditionalpremium(otherthansaying
thatitshouldbelargerforinvestmentsthatareilliquidwhen
themarketisilliquid).Therearethreepracticalsolutionsto
the estimation problem:
1.Addaconstantilliquiditypremiumtothediscountratefor
all illiquid assets to reflect the higher returns earned
historically by less liquid (but still traded) investments,
relativetotherestofthemarket.Thisisakintoanothervery
commonadjustmentmadetodiscountratesinpractice,which
isthesmallstockpremium.Thecostsofequityforsmaller
companiesareoftenaugmentedby 3 to3.5percent,reflecting
theexcessreturnsearnedbysmaller-capcompaniesoververy
longperiods.Thesamehistoricaldatathatwerelyonforthe
smallstockpremiumcanprovideuswithanestimateofan
illiquidity premium.
- Practitionersattributeallora significantportionof
the small stock premium reported by Ibbotson
Associatestoilliquidityandadditonasanilliquidity
premium.Note,though,thateventhesmalleststocks
listed in Ibbotson’s sample areseveral magnitudes
largerthanthetypicalprivatecompanyandaremore
liquid. - Analternativeestimateofthepremiumemergesfrom
studiesthatlookatventurecapitalreturnsoverlong