Possibility of going public in the future. In particular, a firm with strong income and positive cash flows should be subject to a smaller illiquidity discount than one with negative income and cash flows. A private firm that is financially healthy should be easier to sell than one that is not healthy. A private firm with significant holdings of cash and marketable securities should have a lower illiquidity discount than one with factories or other assets for which there are relatively few buyers.įinancial health and cash flows of the firm. The fact that a private firm is difficult to sell may be rendered moot if its assets are liquid and can be sold with no significant loss in value. According to Aswath Damodaran, there are macro factors that impact liquidity, as outlined below. This is a non-optimal approach as levels of liquidity and therefore the subsequent illiquidity discounts applied should vary between markets, sectors, assets, investor profiles and even over timeframes employed. However, it is still an engagement challenge given that you are essentially subtracting a potentially huge chunk of company or asset value (or at the very least pointing out that such a discount exists), especially as often, such discounts are calculated subjectively or via ‘rules of thumb’. Although, conversely, it is also reasonably intuitive to business owners and investors that private companies typically sell at a price discount compared to otherwise comparative public companies.
DISCOUNT LIQUIDATION HOW TO
One challenge for many business valuation reports is therefore how to effectively communicate the value of a nonmarketable equity interest, particularly the rationale for the selected discount for lack of marketability (DLOM). In other words, liquidity can be conceptualised as impacting pricing and not necessarily intrinsic value. The delta between intrinsic valuation and pricing is, after all, a function of liquidity, not to mention potentially a number of other qualitative and quantitative factors (that in turn help increase or decrease liquidity). Obtaining valuable insight around comparable company transactions is notoriously difficult, but if such information is available, it will be the final transaction price rather than current fundamental value that is reported. How large should a liquidity discount be for any given company? This is a technical challenge given that the discount itself is not explicit. Indeed, such ‘liquidity discounts’ can reach up to 50 percent of estimated fundamental value. Nonetheless, it is in private markets where liquidity is a key issue in asset valuation and can significantly affect value, or more specifically ‘pricing’. In publicly traded equity markets, liquidity factors may be minimal and simpler, even though they still exist. Determining a private company’s worth and knowing “what drives its value is a prerequisite for deciding on the appropriate price to pay or receive in an acquisition, merger transaction, corporate restructuring, sale of securities, and other taxable events”, according to PrivCo. After all, valuation is a process used to determine what a business is worth. Regardless of whether you are doing valuation based on intrinsic economic value, comparing against how similar assets are priced (multiples) or pricing via real options (contingent claim valuation), illiquidity impacts value, both in terms of cash flow considerations and asset allocation decisions. For example, the promptness of an asset’s conversion into cash – not the certainty of its selling or conversion price.
Marketability, on the other hand, is linked to transaction velocity. Sometimes the word ‘liquidity’ is applied to assets that are simply convertible to cash, for example, savings accounts, bank CDs and money market accounts, as opposed to assets that are sold on the secondary market. Liquidity involves both speed of the transaction and visibility around its selling price. Liquidity risk is an aspect of the secondary market. Liquidity and marketability are often confused.
Investors value liquidity and would pay more for an asset that is fully liquid than for an otherwise identical asset that is not fully liquid. Liquidity refers to the ease in which an asset can be converted into cash, with cash being fully liquid and other securities liquid, to varying degrees. In financial markets, asset liquidity is a key and active consideration.
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