Abstract: Some business valuators apply a “size premium” when estimating the cost of equity. The underlying theory is that investors might require additional returns for increased risk associated with investments in smaller companies. But whether the premium is appropriate remains subject to debate. This article looks at the pros and cons of both sides.
The cost of equity
Does size matter in business valuation?
Thirty-five years ago, Dr. Rolf Banz of the University of Chicago first identified what he called the “size effect.” He conducted research that revealed that smaller firms had higher risk-adjusted returns on average than larger firms. Based on this finding, some business valuators apply a “size premium” (also known as a small cap premium) when estimating the cost of equity. The underlying theory is that investors might require additional returns for increased risk associated with investments in smaller companies. But whether the premium is appropriate remains subject to debate.
Applying the premium
The cost of equity is a component of discount rates used in discounted cash flow analyses. It captures the returns investors require for holding shares of stock in the subject company. In his 1981 study, Dr. Banz noted that valuators, when estimating the cost of equity, assume a simple linear relationship between the expected return and the risk. That is, the required return increases proportionally to increases in risk. But he found that systematic risk explained only part of the higher returns generated by smaller companies.
The size premium is intended to account for the incremental returns that investors in small firms require. A valuator who applies a size premium when valuing a smaller company generally adds it when using the capital asset pricing model or a build-up model to estimate the cost of equity. This increases the discount rate and reduces the value, if all else is the same.
Debating the issue
Questions have arisen over the validity of Dr. Banz’s findings today. Some have noted, for example, that studies finding statistically significant evidence of a size premium usually relied on data from before 1981. But some research conducted with data from after 1981 suggests that a statistically significant relationship no longer exists.
Other research suggests that the size premium still exists if historical data on returns is modified to adjust for company-specific factors. Examples of these qualitative factors include profitability, growth and stability of earnings. The research asserts that, once these factors are adjusted for, the size premium is indeed real.
The question of whether investors require size premiums to compensate them for investing in small companies remains unsettled (as does, for that matter, the question of what qualifies as “small”). If the use of a size premium comes up in litigation, it’s essential that your valuation expert understand the relevant issues in this ongoing debate and can defend his or her position with the latest market research.