The Valuation Handbook: Valuation Techniques from Today's Top Practitioners

CHAPTER 18

Measures of Discount for Lack of Marketability and Liquidity

 

Ashok Abbott, Ph.D.

Associate Professor of Finance, West Virginia University

 

 

Fair market value is defined as the price at which an asset will change hands between a willing buyer and a willing seller, neither party being under compulsion to buy or sell, and both having reasonable knowledge of relevant facts. It is generally accepted that equity interests in small, closely held businesses are not readily marketable and may be relatively illiquid. Estimating the loss in value due to lack of marketability and liquidity is not merely an academic issue. Investors, owners of small businesses, and tax authorities frequently need to make an estimate of realizable value in the case of a willing buyer not being readily available.

In fact, a better theoretically sound, empirically validated model framework on illiquidity effects can provide immense economic understanding of the recent market turmoil induced by the freeze-up and meltdown of markets. This chapter addresses this model framework.

PUBLICLY TRADED EQUIVALENT VALUE

Public markets based approaches in business valuation practice are designed to convert a stream of anticipated cash flows from ownership of a closely held business to a present value. This conversion can be achieved by using a multiple, such as a price-to-sales ratio, or a more sophisticated, but functionally equivalent, application of capitalizing a cash flow stream using a required rate of ...