Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CONCLUSION

We have provided a tutorial on applying the Longstaff model to the valuation of illiquid common stock. Although the model does not produce an exact discount for the valuation of illiquid stocks, it provides an upper bound that is a useful starting point for valuing illiquid stock. The model is also parsimonious, has a closed form, and requires only two inputs—namely, the volatility of the stock return and the length of time the stock is illiquid.

Using volatility as an input provides a more analytical approach to determining discounts than is provided by current practices because it explicitly takes into account the put option inherent in a liquid asset. Previous studies examined the relationship between the discount to the value of restricted stock and such variables as size and leverage, but these analyses are ad hoc. Illiquid stock has a lower value than liquid stock because of the opportunity cost of being locked into holding an illiquid asset. This cost arises as a result of stock price fluctuations, and stock return volatility is a good measure of stock price fluctuation.

Finally, we want to point out that the basic framework of Longstaff’s model is also useful for understanding the relationships among illiquidity, risk, and returns for other types of assets, such as hedge funds and private equity limited partnerships. For example, Liang and Park (2007) documented that many hedge funds impose various liquidity restrictions on investors, such as lockups and redemption ...