Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CHAPTER 14

VALUING ILLIQUID COMMON STOCKa

Edward A. Dyl and George J. Jiang

Illiquid common stock is worth less than stock that can be readily sold because the investor incurs an opportunity cost by being locked into the investment. Quantifying the amount of this illiquidity discount is an important issue in valuing certain common stock, especially for estate valuations. We examine whether a previously developed analytical model for valuing the lost “option to sell” when a stock is illiquid is a useful, practical tool for valuing illiquid common stock.

Some common stock cannot be easily liquidated. The stock of companies that are not publicly traded is an obvious example. Restricted stock in publicly traded companies may also be illiquid when the restrictions prohibit its sale. A formal contractual agreement when the stock is issued (e.g., letter stock) may limit liquidity, or the shares may be illiquid because they are not registered with the U.S. SEC. Unregistered stock in publicly traded companies is subject to selling limitations under Rule 144, which mandates a minimum holding period of one year for unregistered stock and also limits how much stock can subsequently be sold by an individual in any three-month period.1 Finally, a large holding of a particular common stock is essentially illiquid if the underlying public market for the stock is thin relative to the size of the block. For example, blocks of stock in secondary distributions generally sell at a price lower than ...