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Effect of Liquidity on Size Premium and its Implications for Financial Valuations

Abstract Courts are often required to determine a stock’s “fair value,” which by definition excludes any reduction to value because of a lack of liquidity. The method of computing fair value most frequently used by practitioners is the discounted cash flow analysis, which requires calculating the cost of equity. Over the last decade, many practitioners have included a size premium in the computation of the cost of equity based on the finding that historic returns for firms with lower market capitalization are greater than the returns implied by the standard capital asset pricing model. Our findings show that a substantial fraction of the measurement of size premiums reflects a lack of liquidity, which disproportionately affects smaller sized companies. Because a reduction to value from illiquidity should not be reflected in the measurement of fair value, this finding has implications for assessments of fair value that employ the commonly used size premiums. Specifically, our findings suggest that valuations of small capitalization stocks that reflect these size premiums will cause the fair value to be underestimated because of the effect of lower liquidity. The smaller the size, the greater is the underestimation in value.