Valuing Illiquid Common Stock

Edward A. Dyl and George J. Jiang

Financial Analysts Journal, 2008, vol. 64, issue 4, 40-47

Abstract: 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.The value of an illiquid asset is generally lower than that of a similar asset that is readily marketable. Investors value liquidity because its absence limits the owner’s option to convert the asset to cash; thus, illiquidity increases potential opportunity costs. Investors locked into a holding of nonmarketable stock are subject to losses resulting from changing stock prices.Valuations of illiquid stock are required for estate valuations for tax purposes, merger and acquisition transactions, divorce settlements and other forms of partnership dissolutions, and situations in which the valuation has important financial consequences for the parties involved. Therefore, valuing illiquid stock can be a contentious issue, and it frequently involves large amounts of money. We examine the usefulness of an options-based framework developed in 1995 to estimate the value of the marketability (i.e., liquidity) of a particular common stock for a particular investor at a particular time. This model explicitly takes into account the put option inherent in a liquid asset. It requires two inputs—namely, the volatility of the shares’ returns and the length of time for which the shares are illiquid. We first report cross-sectional variations in volatility for NYSE and NASDAQ stocks. We then apply the model in an actual case study to assess the extent to which the illiquidity discount for a specific stock holding depends on the volatility of the company’s stock and on other characteristics of the case. We conclude that the model provides a more analytical approach to determining discounts than do current practices but that there is still a role for judgment in determining the appropriate discount in a specific case.

Date: 2008
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DOI: 10.2469/faj.v64.n4.4

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