Less-liquid stocks have higher expected returns than more- liquid stocks.
Liquidity has many different, but similar meanings. In every case, it is related to the ease of movement. In the banking system, liquidity measures the degree to which loans are made. In the securities markets, liquidity is the ease with which transactions can be made. In valuation, liquidity has an impact on value: The more liquidity an asset has, the more value it has, all other things being equal. The absence of liquidity lowers the value of the asset by the amount of an illiquidity discount.
In the financial crisis, it is quite natural that the financial media are focusing on liquidity in bonds and loans. The president and Congress are providing bailout money so that financial institutions can prop up balance sheets to make it easier for them to start lending again. Corporations, such as automobile manufacturers, are not able to meet their cash flows with their illiquid assets and cannot get sufficient financing. Potentially healthy corporations or individuals are not able to get refinancing as their loans become due.
In this article, we instead focus on liquidity as the ease of executing securities in general, especially equities. We focus on liquidity's impact on valuation and in particular its impact on security returns. We will demonstrate that less-liquid securities have higher expected returns.
Valuation as Present Value of Cash Flows
In equilibrium, an asset has a value that equals its present value, or the discounted sum of its expected cash flows. These future cash flows are unobservable, except for risk-free assets. For stocks, there is great disagreement as to what these expected cash flows might be. This disagreement is the primary reason that stocks are traded. A secondary reason is that they are bought or sold to meet liquidity needs.
The other component of a present value calculation is the discount rate. Similar to the expected cash flows, these discount rates are unobservable. We can usually observe the riskless discount rates from a term structure of riskless bonds, which we unravel from U.S. government discount bonds. But there are usually other premiums that we would add to the riskless term structure. The most common one is an equity risk premium, which is often modified by a beta in the CAPM framework. We might also add a premium for size and another one for value (or distress). We argue here that another premium should be added for lack of liquidity.
The difference of opinion that investors have about expected cash flows leads to the additional risk of a security. The risk of the security reflects not only the changing economy and company cash-flow expectations, but also the divergence of opinion that changes from moment to moment. This risk reduces the value of a security. Ironically, this divergence of opinion also leads to most of the trading of a security, thereby making the security more liquid for traders, whether they be active or liquidity traders. The higher liquidity increases the security's value.
We do not mean to imply that most investors actually make these present value calculations. Instead, investors rely on simple metrics, such as the price/earnings ratio. They try to buy stocks with relatively high but unspecified cash-flow projections at relatively low P/E ratios. Or they may simply think that a stock's price is too low or high relative to its estimated value, leading them to buy or sell a security.
The Illiquidity Premium
Most conventional present value calculations ignore the illiquidity premium. These calculations usually implicitly assume that securities are perfectly liquid. If they are somewhat illiquid, an illiquidity discount is often made to the present value, at the end of the calculation. Thus, a liquid stock is priced at the present value of the expected cash flows, discounted by the riskless rate and various other risk premiums, such as a beta-adjusted equity risk premium, a size premium, and a value premium. The final present value is then reduced by some percentage because of its lack of liquidity.