Damodaran on Valuation

14.6. CONCLUSION

Illiquidity matters. Investors are generally willing to pay higher prices for more liquid assets than for otherwise similar illiquid assets. While this proposition is widely accepted, there is substantial debate about how to measure illiquidity and how to incorporate it into value. In this chapter, we began by relating illiquidity to transactions costs; less liquid investments have higher costs of transacting, especially if we define these costs broadly to include the bid-ask spread and a price impact. We then looked at the empirical evidence on how much markets value liquidity. Considering a broad array of investments, from government bonds to private equity, the consensus conclusion that we draw is that illiquid investments trade at lower prices than liquid investments and generate higher returns. The magnitude of the illiquidity discount varies across investments, with riskier investments bearing larger illiquidity discounts, and across time, with the discounts being greatest when the overall market itself is least liquid.

In the next part of the chapter, we considered different ways of incorporating illiquidity into value. In discounted cash flow valuations, we can either value an asset or business first as a liquid asset and then apply an illiquidity discount, or adjust the discount rate to reflect illiquidity (by adding a premium for illiquid investments). In either case, the adjustment should reflect firm-specific factors and be larger for some assets (risky ...