A CAPM-Based Approach to Calculating Illiquidity Discounts

11 November 2002
By Dr. David Tabak

When an asset is believed to be illiquid or lack marketability, the estimated value of the asset may be reduced (or discounted) due to the perceived difficulty in selling the asset. These "illiquidity discounts" are often applied in the valuations of securities, such as restricted stock, and in the valuations of businesses or business opportunities. While there is limited (and likely biased) evidence on the average size of illiquidity discounts in the past, this evidence does not allow an analyst to accurately determine the discount for a particular stock without making highly subjective decisions about how an individual case compares to the average.

In this working paper, Dr. Tabak provides a review and analysis of existing studies and theories on calculating appropriate illiquidity discounts for restricted stock. Dr. Tabak discusses how existing studies have limited applicability in calculating an appropriate discount because they generally present only median or average results. As an alternative, Dr. Tabak offers a theoretical model based on the CAPM, or capital asset pricing model, that allows for a quantification of the illiquidity discount based on objective criteria specific to the asset under consideration. This equity risk premium-based model is the first approach to apply the CAPM to the process of calculating illiquidity discounts, and offers a number of benefits over using simple average discounts or any of the other methodologies discussed in this paper. The result is a framework for measuring illiquidity discounts that vary over time and depend on the length of the restriction and the riskiness of the illiquid asset. Perhaps most importantly, Dr. Tabak's new model is less subjective than the analysis often used in practice today.