Illiquidity discount in valuation of private firms in india
Answers
Explanation:
Illiquidity Discount
When you invest in an asset, you generally would like to preserve the option to liquidate that investment if you need to. The need for liquidity arises not only because your views on the asset value change over time-you may perceive it as a bargain today, but it may become overpriced in the future-but also because you may need the cash from the liquidation to meet other contingencies. Some assets can be liquidated with almost no cost-Treasury bills are a good example-whereas others involve larger costs-such as stock in a lightly traded over-the-counter stock or real estate. With investments in a private business, liquidation cost as a percent of firm value can be substantial. Consequently, the value of equity in a private business may need to be discounted for this potential illiquidity. In this section, we will consider measures of illiquidity, how much investors value illiquidity, and how analysts try to incorporate illiquidity into value.
Measuring Illiquidity
You can sell any asset, no matter how illiquid it is perceived to be, if you are willing to accept a lower price for it. Consequently, we should not categorize assets into liquid and illiquid assets but allow for a continuum un liquidity, where all assets are illiquid but the degree of illiquidity varies across them. One way of capturing the cost of illiquidity is through transactions costs, with less liquid assets bearing higher transactions costs (as a percent of asset value) than more liquid assets.
With publicly traded stock, some investors undoubtedly operate under the misconception that the only cost of trading is the brokerage commission that they pay when they buy or sell assets. Although this might be the only cost that they pay explicitly, they will incur other costs in the course of trading that generally dwarf the commission cost. When we trade any asset, there are three other ingredients that go into the trading costs.
The first cost is the spread between the price at which you can buy an asset (the dealer’s ask price) and the price at which you can sell the same asset at the same point in time (the dealer’s bid price). For heavily traded stocks on the New York Stock Exchange, this cost will be small (10 cents on a $50 stock, for instance), but the costs will increase as we move to smaller, less-traded companies. A lightly traded stock may have an ask price of $2.50 and a bid price of $2.00, and the resulting bid-ask spread of 50 cents will be 20 percent of the ask price.