Business valuation and liquidity

Take a look at the public capital markets, and one thing becomes immediately obvious: the higher the shares turnover for a given company, the higher its valuation tends to be. This is because investors love liquidity, i.e. the ability to trade business ownership interests quickly, with minimal costs, and at a predictable price.

Smaller companies are usually less liquid, with fewer shares trading on a given day. The result is that such companies have to generate higher returns to attract the investors.

In the formal language of business valuation, the companies that are less liquid have a higher cost of capital and higher returns than their larger, more liquid counterparts.

The situation with private companies is even more challenging. There is no direct measure of liquidity because these companies do not sell stock to the public. So there are no reported stock prices to go by.

This relative lack of liquidity for private companies has a very strong effect on their value. In numerical terms, the company’s discount or capitalization rates are increased.

Public capital markets are silent as to how much this lack of liquidity affects the value of private companies. The way you can account for this is to calculate the values of similar public companies whose stocks are actively traded and then apply a marketability discount when valuing a private firm.

You can’t assess the impact of low liquidity directly by looking at the private companies. However, you can estimate the levels of relative lack of liquidity by studying public companies whose stock turnover differs.

Pick two sets of companies, one comprised of large, actively traded firms, the other consisting of companies whose stock sells on occasion. You will notice the significant difference in historical returns. The lower the trade volume, the higher the returns required to keep the investors happy.

Note that this liquidity value premium is not to be confused with company size. To see this, compare returns of companies that trade at about the same volume but differ in size. You will see that the company size, i.e. market capitalization, is an independent predictor of returns. Larger firms tend to have lower returns, no matter the liquidity.

See Valuation Tour