Both the theory and the empirical evidence suggest that illiquidity matters and that investors attach a lower price to assets that are more illiquid than to otherwise similar assets that are liquid. The question that we face when valuing assets, then, is how best to show this illiquidity. In this section, we consider three alternatives. The first is to value an asset or business as if it were a liquid investment, and then to apply an illiquidity discount to that value. The second is to adjust the discount rate used in a discounted cash flow valuation for the illiquidity of the asset; more illiquid assets will have higher discount rates. The third is through relative valuation, by valuing an asset based on how assets of similar liquidity have been priced in transactions. In this section, we consider all three.

14.4.1. Illiquidity Discounts on Value

In conventional valuation, there is little scope for showing the effect of illiquidity. The cash flows are expected cash flows, the discount rate is usually reflective of the risk in the cash flows and the present value we obtain is the value for a liquid business. With publicly traded firms, we then use this value, making the implicit assumption that illiquidity is not a large enough problem to factor into valuation. In private company valuations, analysts have been less willing (with good reason) to make this assumption. The standard practice in many private company valuations is to apply ...

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