Liquidity

The ease and speed with which savers can get rid of an asset.

Cash is highly liquid, but real estate is not.

Savers should consider not just the rate of return, but also the risk and liquidity of an asset before choosing to invest in it.

A general rule:

• Stocks with higher liquidity will have a lower WACC (cost of capital), and a lower required return.  

• Stocks with lower liquidity (more difficult to sell), will have higher WACC, and a higher required return. 

This is because the higher cost of trading the less liquid stock, that reduces the total return that an investor would see, so...as a consequence...the investor requires a higher return for the stock that is more difficult to trade.

Real estate

One key issue in the real estate market is liquidity, which you can think of as the time it takes to sell your home.  As far as liquidity goes, a condominium in a large metropolitan area is generally quite liquid, and might sell within days or weeks of being put on the market.  But a family home in the suburbs is generally less liquid, and might take months to sell.

Stocks

The concept iof liquidity is similar in the stock market, but in this case we are not talking about the speed, but instead about the cost with which they can be traded. 

There are 3 costs to consider:

1.  brokerage fees

2.  bid-ask spread

3.  market-impact costs - some stocks require large bulk purchases (like Berkshire-Hathaway, for example).  So, the stock is less liquid because common people cant afford to buy just one share.

How to increase your liquidity (and decrease your WACC).

In order to reduce your cost of capital (the cost of borrowing money, otherwise know as WACC)....you should always try to increase liquidity, which means decreasing the transaction cost of trading your companies stock.  Since you cant directly control item #1 (brokerage fees), this means focusing on items #2 (bid-ask spread) directly, and #3 (market-impact costs) indirectly.

The key to control is the bid-ask spread, which will be higher if the broker is worried that there is an imbalance between informed and uninformed traders.  An informed trader would be someone with knowledge that the broker is unaware of.  These would be the large, sophisticated dealers.  On the other hand, there are the uninformed traders.   If the broker is worried about information thats not known, then he will increase the bid-ask spread, and that will cause an increase in your WACC. 

So, to decrease the WACC, you need to put out lots of information for traders.  By increasing the pool of informed traders, you will decrease the bid-ask spread, and increase the LIQUIDITY of your stock, thereby reducing your cost of capital. 

There are some people that make a career out of being a security analyst (see careers - security analyst).  These people only typically cover large companies.  If you are with a small, uncovered company, then it is in your best interest to release a ton of information yourself, and hope that you get analyst coverage.  This is not to drive up the price of your stock, but instead is to increase the LIQUIDITY of your stock, and drive down your cost of capital. 

Related Pages

see our discussion on the differences between a Liquidity Crisis and a Solvency Crisis