small company listed over-the-counter is muchless liquid
than a midsize company listed on the New York Stock
Exchange, which in turn is much less liquid than a
large-capitalization company that iswidely held.If, as we
argued earlier, the bid-ask spread is a measure of the
illiquidityofastock,wecancomputethespreadasapercent
ofthemarketpriceandrelateittoacompany’sfundamentals.
Whilethebid-askspread mightbeonlya quarterorhalfa
dollar,itloomsasamuchlargercostwhenitisstatedasa
percentofthepricepershare.Forastockthatistradingat$2,
withabid-askspreadofaquarter,thiscostis12.5percent.
For higher-priced and very liquid stocks, the illiq-uidity
discountmaybelessthan0.25percentoftheprice,butitis
not zero. What relevance does this have for illiquidity
discountsonprivatecompanies?Thinkofequityinaprivate
companyasastockthatnevertrades.Onthecontinuumjust
described,youwouldexpectthebid-askspreadtobehighfor
such a stock, and this would essentially measure the
illiquidity discount.
To make estimates of the illiquidity discounts using the
bid-askspreadasthemeasure,youwouldneedtorelatethe
bid-askspreadsofpubliclytradedstockstovariablesthatcan
bemeasuredforaprivatebusiness.Forinstance,youcould
regressthebid-askspreadagainsttherevenuesofthefirmand
adummyvariable,reflectingwhetherthefirmisprofitable,
andextendtheregressiondoneonrestrictedstockstoamuch
largersample.Youcouldevenconsiderthetradingvolume
forpubliclytradedstocksasanindependentvariableandsetit
tozeroforaprivatefirm.Usingdatafromtheendof2000,
forinstance,weregressedthebid-askspreadagainstannual
revenues,adummyvariableforpositiveearnings(DERN: 0 if