definethesecostsbroadlytoincludethebid-askspreadanda
priceimpact.Wethenlookedattheempirical evidenceon
howmuchmarketsvalueliquidity.Consideringabroadarray
ofinvestments,fromgovernmentbondstoprivateequity,the
consensusconclusionthatwedrawisthatilliquidinvestments
trade atlower pricesthan liquidinvestments and generate
higher returns. The magnitude of the illiquidity discount
varies acrossinvestments, with riskierinvestments bearing
larger illiquidity discounts, and across time, with the
discountsbeinggreatestwhentheoverallmarketitselfisleast
liquid.
Inthenextpartofthechapter,weconsidereddifferentways
ofincorporatingilliquidityintovalue.Indiscountedcashflow
valuations,wecaneithervalueanassetorbusinessfirstasa
liquidassetandthenapplyanilliquiditydiscount,oradjust
thediscountratetoreflectilliquidity(byaddingapremium
forilliquidinvestments).Ineithercase,theadjustmentshould
reflect firm-specific factors and be larger for some assets
(risky and troubled firms) than for others. In relative
valuation,wecanattempttobypasstheestimationissueby
findingtransactionspricesonsimilarilliquidassetsandusing
thisinformationtopricetheassetinquestion.Ifthisisnot
possible,wehavetorelyonadjustingtherelativevaluefor
illiquidityinmuchthesamewayasweadjustdiscountedcash
flow valuations.
The question of how illiquidity affects value has
consequencesforbothinvestorsandfinancialmanagers.For
investors,itpinpointstheimportanceoffindinganinvestment
strategythatmatchestimehorizon;lessliquidinvestmentsare
much better suited for long-term investors. For financial
managers,theperceivedliquidityofthefirm’ssecuritiesand