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

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MEASURING STOCK LIQUIDITY

There are many different alternative measures of absolute and relative stock liquidity (e.g., ADTV, float, ADTV/shares outstanding), but until recently, there were no corresponding market benchmarks to identify the approximate levels at which the effects of illiquidity generally became prevalent. Though we focus on liquidity discounts, bid-ask spreads are an indication of liquidity. Empirically, evidence shows they tend to widen as a result of underlying liquidity. However, they are more a result than a driver of liquidity, and though popular among investment finance academics, they are less intuitive, actionable, and commonly used in corporate finance. Bid-ask data have limited availability in FactSet and are not disclosed in company filings.

Benchmarks for absolute liquidity are $1 million ADTV and $150 million float. Based on our own empirical analysis, we would generally expect to see the impact of illiquidity—including a potential impairment in value, market access, and other associated trading problems—at levels below these benchmarks. However, these problems can be affected by other qualitative factors, such as disclosure and research coverage.5

From a statistical significance perspective (two-tailed t-test on the relative valuations in the bottom quintile of stock liquidity versus the top half of stock liquidity), ADTV and float are the most useful measures of stock liquidity. We discard the natural logarithm (ln) of market capitalization as a ...

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