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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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CHAPTER 9

The Stock Liquidity Handbook

Stock liquidity is an important consideration for many corporate finance decisions, including primary or secondary issuance, stock splits, share repurchases, and special dividends.

Stock illiquidity makes it difficult for investors to enter or exit a position without affecting price. It is also difficult to accumulate a sufficiently meaningful stake in an illiquid stock, which is important to investors because of the large fixed cost of maintaining research coverage for any one stock. Illiquidity creates practical limitations and inefficiencies for investors that can ultimately manifest in unusual ownership profiles and trading patterns, a higher bid-ask spread, a higher cost of equity, a lower stock price, and difficulties with market access. One study found that valuation discounts were directly attributable to the effects of liquidity: Illiquid securities exhibited greater sensitivity to market movements and exhibited higher trading costs, such that investors would expect a higher rate of return, thus raising the cost of equity.1

Changes to the securities industry are making stock liquidity more important. About 682 public companies have lost sell-side coverage since 2002, and 35 percent of all public companies lack research coverage.2 More companies must now take their story to the street. One survey indicates that some CFOs spend as much as 50 percent of their time on investor relation activities.3

Much of the literature in this area ...

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