Damodaran on Valuation

14.2. COST OF ILLIQUIDITY: THEORY

The notion that investors will pay less for illiquid assets than for otherwise similar liquid assets is neither new nor revolutionary. Over the past two decades researchers have examined the effect of illiquidity on value using three different approaches. In the first, the value of an asset is reduced by the present value of expected future transactions costs, thus creating a discount on value. In the second, the required rate of return on an asset is adjusted to reflect its illiquidity, with higher required rates of return (and lower values) for less liquid assets. In the third, the loss of liquidity is valued as an option, where the holder of the illiquid asset is assumed to lose the option to sell the asset when it has a high price. All three arrive at the conclusion that an illiquid asset should trade at a lower price than an otherwise similar liquid asset.

14.2.1. Illiquidity Discount on Value

Assume that you are an investor trying to determine how much you should pay for an asset. In making this determination, you have to consider the cash flows that the asset will generate for you and how risky these cash flows are to arrive at an estimate of intrinsic value. You will also have to consider how much it will cost you to sell this asset when you decide to divest it in the future. In fact, if the investor buying it from you builds in a similar estimate of transactions cost she will face when she sells it, the value of the asset today should ...