Public Values, Private Values

How much is a stock worth?

Chicago Board of Trade. Source: Wikipedia

The short answer is, whatever someone else will pay for it. But what if there isn’t much of a market? What if the shares trade “by appointment,” only changing hands when there are motivated buyers and sellers? If you don’t have access to a private valuation consultant, what do you do?

Other markets deal with infrequent trading and illiquidity all the time. Bonds and real estate are both idiosyncratic – no bond and no house is exactly like another. But they have certain similarities. So, folks compare the features of the asset they hold with something that has lots of frequent buyers and sellers and they make certain adjustments. In the case of a home, we would adjust for square footage, bedrooms and bathrooms, recent renovations, and location. In the case of bonds, we compare them with Treasury bonds and adjust for credit risk. After all, the final question with bonds is whether you’ll get your money back when they mature.

With stocks, analysts look at earnings, growth, cash flow, and market position. They apply multiples to these measures to get a theoretical fair value. Then they apply a discount for illiquidity. The illiquidity-discount depends on several factors – how many shares trade over a particular period, the riskiness of the underlying business, and the share price volatility

This only makes sense. If a stock isn’t very volatile and you can move out of your position in just a few months, then not much of a discount is needed. If, on the other hand, it would take several years for you to sell your shares and the business is highly risky – think of highly levered oil wildcatters – then a big discount should apply.

Source: CFA Institute, Financial Analysts Journal

This matters, particularly in estate valuations. If an estate holds a large position in an illiquid firm, that market value should be discounted. As a practical matter, though, an expert’s valuation is just a starting point for negotiations with the IRS. But this also should apply to illiquid investment vehicles like hedge funds and private equity. They usually impose restrictions on investors, like lockups and redemption fees. These are worth something. Investors should pay less and get higher returns in exchange.

Liquidity restriction. Photo: Mark Bukawicki Source: Wikipedia

There’s no free lunch, but the ability sell an asset at will is the standard assumption in many textbooks. Markets aren’t perfectly liquid, though. If investors don’t value the liquidity (or illiquidity) of what they own, they’re cheating themselves.

Douglas R. Tengdin, CFA

By | 2017-07-17T12:21:27+00:00 March 17th, 2017|Global Market Update|0 Comments

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