August 07, 2008


Researchers have been trying to establish a reliable way of determining the level of the "liquidity discount" for private firms.  Privately held companies usually have lower market values than publicly traded firms due to their relative lack of liquidity.

"There's a vast difference between trading public companies and private companies," says Dr. Stanley Block, professor of finance at the Neeley School of Business at TCU. "Private companies have less value because you don't have the option of easily selling the shares. That's the liquidity discount. When it comes to buying or selling, or estate or divorce settlements or bank loan valuations, private companies simply cannot be assessed the same as public companies," he says.

His new study using updated techniques has uncovered insights that should be very meaningful to potential buyers and current owners of private companies. "The Liquidity Discount in Valuing Privately Owned Companies," by Dr. Block, appears in the June 2008 issue of the Journal of Applied Finance.

The study is the first to compare liquidity discounts among different industries. In so doing, it found distinctly divergent levels for certain types of firms.

 "In comparing results among industries, I found that companies in certain industries are more liquid or illiquid than in others," he says.

Specifically, privately held firms in the financial industry tend to experience only a modest liquidity discount, presumably because the assets themselves are liquid by their very nature. Conversely, heavy manufacturers have a much higher liquidity discount because their assets are more difficult to value and convert into cash.

"A potential buyer, lawyer, or loan officer can now reference the liquidity discount by industry, and owners of private companies can better determine what their shares are worth to avoid making big mistakes during transactions," Dr. Block suggests.

Dr. Block studied 91 private domestic firms that sold a controlling interest to new owners during 1999-2006. He divided them into eight categories by industry: energy, finance, health care, manufacturing, retail, technology, transportation and utilities. Paired with each private firm was a public company that had undergone a similar transaction within the same industry and during the same year. The proportions among categories were representative of those found in the marketplace.

All 182 companies were analyzed according to five financial ratios: price to earnings per share, enterprise value to book value, enterprise value to revenue, enterprise value to EBIT (earnings before interest and taxes), and enterprise value to EBITDA (earnings before interest, taxes, depreciation, and amortization).

Dr. Block compared the results for the private firms to those of the public firms to determine the liquidity discounts by industry. For six of the industries, the discounts were fairly similar at around 20 to 25 percent. However, for financial firms, the discounts hovered around 10 percent, while manufacturers experienced 30 to 40 percent.

By examining differences among industries, fairly recent acquisitions, and multiple financial ratios, Dr. Block's study significantly advances the understanding of liquidity discounts.

Older studies had looked at transactions from earlier time periods and based their analyses on either the sales of restricted stocks or comparisons of pre-IPO prices with post-IPO prices.

"Both the restricted stock approach and the IPO approach have serious limitations that do not occur in my investigation," says Dr. Block.

In addition to the markdown for limited liquidity, discounts on restricted stocks (which cannot be sold for one year after purchase) may reflect special pricing to major investors, as well as the greater costs required for information and monitoring.

Similar effects may occur in pre-IPO studies, with company owners and managers receiving "a sweetheart deal," he says. Also, pre-IPO studies are skewed toward firms that successfully go public because companies that never make it to the IPO stage are necessarily excluded. Dr. Block refers to this as a "survivorship bias."

Additionally, changes in SEC regulations in 1990 and 1997 had the effect of reducing the liquidity discount of restricted stocks, rendering earlier studies essentially obsolete.

"My research is more up to date and goes beyond restricted stock and pre-IPO studies with the comparison by industry and the financial valuation multipliers, which is a more valuable approach," says Dr. Block.


Elaine Cole
Public Relations Manager
Neeley School of Business at TCU