6.6 Size premium
7 min read•august 21, 2024
is a crucial concept in business valuation, reflecting the higher returns investors expect from smaller companies due to increased risk. This premium impacts the cost of capital, affecting valuations and investment decisions for companies of different sizes.
Calculating size premium involves methods like , revenue-based, and total assets approaches. Factors influencing the premium include , information availability, and . Understanding these elements is essential for accurate risk assessment in business valuation.
Definition of size premium
- Size premium refers to the additional return investors expect from smaller companies due to perceived higher risk
- Plays a crucial role in business valuation by affecting the cost of capital for companies of different sizes
- Impacts investment decisions and portfolio management strategies in the context of company valuations
Small cap vs large cap
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- companies typically have market capitalizations below $2 billion
- companies generally have market capitalizations exceeding $10 billion
- Small caps often exhibit higher volatility and potentially higher returns compared to large caps
- Liquidity differences between small and large caps affect trading costs and ease of transactions
Historical evidence for premium
- Banz (1981) study first documented the size effect in stock returns
- Long-term data shows small cap stocks outperforming large caps by an average of 2-3% annually
- Premium varies over time, with periods of underperformance and outperformance
- Evidence suggests size premium may be more pronounced in certain market conditions (economic expansions)
Calculation methods
- Calculation of size premium is essential for accurate business valuation and risk assessment
- Methods aim to quantify the additional risk associated with smaller companies
- Choice of calculation method can significantly impact valuation outcomes and investment decisions
Market capitalization approach
- Uses company's market value of equity to determine size category
- Often employs decile breakpoints to classify companies into size groups
- Calculates premium as the difference in returns between small and large cap portfolios
- Widely used due to simplicity and availability of market capitalization data
Revenue-based approach
- Utilizes company's annual revenue as a measure of size
- Particularly useful for valuing private companies without observable market capitalization
- Groups companies into size categories based on revenue thresholds
- Calculates premium by comparing returns of companies in different revenue brackets
Total assets approach
- Employs the book value of total assets as a size metric
- Beneficial for companies with significant non-operating assets or in capital-intensive industries
- Categorizes companies based on asset size and compares returns across categories
- Can provide insights into size premium when market capitalization data is unreliable or unavailable
Factors influencing size premium
- Multiple factors contribute to the existence and magnitude of the size premium
- Understanding these factors is crucial for accurate business valuation and risk assessment
- Factors often interact, creating complex relationships between company size and expected returns
Liquidity considerations
- Smaller companies typically have lower trading volumes and wider bid-ask spreads
- Reduced liquidity can lead to higher transaction costs for investors
- Illiquidity risk may contribute to higher required returns for small cap stocks
- Market makers may demand higher compensation for providing liquidity in small cap stocks
Information availability
- Large cap companies often have more extensive analyst coverage and media attention
- Small caps may suffer from , leading to higher perceived risk
- Limited information can result in greater mispricing and potential for higher returns
- Investors may demand a premium for the additional effort required to research small cap stocks
Operational efficiency
- Smaller companies may have less diversified revenue streams and customer bases
- Large caps often benefit from economies of scale and stronger market positions
- Small caps may be more vulnerable to economic shocks and competitive pressures
- Operational challenges can contribute to higher volatility and perceived risk in small cap stocks
Size premium in CAPM
- is a fundamental tool in business valuation
- Incorporating size premium into CAPM adjusts for the additional risk of smaller companies
- Modified CAPM with size premium provides a more comprehensive risk assessment framework
Adjusting beta for size
- measures a stock's sensitivity to market movements
- Small cap stocks often have higher betas, reflecting greater volatility
- incorporates both market risk and size-related risk
- Calculation:
Fama-French three-factor model
- Expands on CAPM by including size and value factors alongside market risk
- captures the size premium
- Provides a more comprehensive explanation of stock returns than traditional CAPM
- Model:
Criticisms and debates
- Size premium concept has faced scrutiny and challenges in recent years
- Ongoing debates in academic and professional circles about its relevance and persistence
- Understanding criticisms is crucial for making informed decisions in business valuation
Disappearing size effect
- Some studies suggest the size premium has diminished or disappeared since its discovery
- Potential reasons include increased market efficiency and changes in market structure
- Critics argue that the premium may have been a temporary anomaly rather than a persistent factor
- Debate centers on whether the size effect still exists after controlling for other factors (profitability)
Alternative explanations
- Some researchers attribute the size premium to other factors correlated with firm size
- (turn-of-the-year effect) may account for a significant portion of the observed premium
- Liquidity risk and limits to arbitrage could explain the apparent outperformance of small caps
- in historical data may overstate the true size premium
Application in valuation
- Size premium plays a crucial role in determining the cost of capital for companies
- Accurate application of size premium is essential for fair and reliable business valuations
- Valuation professionals must carefully consider how to incorporate size effects into their analyses
Adjusting discount rates
- Size premium is often added to the cost of equity derived from CAPM
- Increases the discount rate used in discounted cash flow (DCF) valuations for smaller companies
- Adjustment formula:
- Magnitude of adjustment varies based on company size and chosen calculation method
Impact on company valuations
- Higher discount rates for smaller companies generally result in lower valuations
- Size premium can significantly affect the present value of projected cash flows
- May influence investment decisions, mergers and acquisitions, and capital budgeting
- Sensitivity analysis often used to assess the impact of different size premium assumptions
Size premium across markets
- Size premium varies across different markets and geographies
- Understanding these variations is crucial for international business valuation and investment decisions
- Market-specific factors can influence the magnitude and persistence of the size premium
Developed vs emerging markets
- Size premium tends to be more pronounced in emerging markets
- Developed markets often have more efficient pricing and lower information asymmetry
- Emerging markets may offer greater opportunities for exploiting the size effect
- Differences in market structure and liquidity can impact the observed size premium
Industry-specific considerations
- Size premium can vary significantly across different industries
- Capital-intensive industries may show different size effects compared to service-based sectors
- Technology and growth industries often exhibit unique size-related return patterns
- Industry-specific size premium adjustments may be necessary for accurate valuations
Historical trends
- Analyzing historical trends in size premium is crucial for understanding its relevance and persistence
- Long-term data provides insights into the stability and variability of the size effect
- Understanding historical patterns helps in making informed decisions about incorporating size premium in valuations
Long-term size premium data
- Studies often use data spanning several decades to analyze size premium
- (now part of Morningstar) provides widely-used historical size premium data
- Long-term average size premium typically ranges from 2% to 5% annually
- Data shows periods of both outperformance and underperformance of small caps relative to large caps
Recent changes in premium
- Some studies suggest a decline in the size premium over the past few decades
- Potential reasons include increased market efficiency and changes in market structure
- Impact of technological advancements on small company competitiveness
- Debate over whether recent trends represent a temporary phenomenon or a permanent shift
Size premium in practice
- Application of size premium in real-world business valuation requires careful consideration
- Practitioners must balance theoretical concepts with practical constraints and market realities
- Understanding how size premium is viewed and applied by various stakeholders is crucial
Analyst perspectives
- Many financial analysts continue to incorporate size premium in their valuation models
- Some analysts argue for more nuanced approaches, considering factors beyond just market capitalization
- Debate over the appropriate magnitude of size premium adjustments in different contexts
- Increasing use of multi-factor models that include size alongside other risk factors
Regulatory considerations
- Regulatory bodies may provide guidance on the use of size premium in certain valuation contexts
- Tax authorities often have specific requirements for incorporating size premium in business valuations
- Financial reporting standards may influence how size premium is applied in fair value measurements
- Regulatory perspectives can vary across jurisdictions, impacting global valuation practices
Risk factors beyond size
- Size premium is one of several risk factors that can affect expected returns and valuations
- Understanding the interplay between size and other risk factors is crucial for comprehensive risk assessment
- Valuation professionals must consider a holistic approach to risk evaluation in business valuation
Complementary risk factors
- Value premium captures the higher expected returns of stocks with low price-to-book ratios
- Momentum factor reflects the tendency of recent price trends to continue
- Profitability factor accounts for the higher expected returns of more profitable companies
- Liquidity risk premium compensates investors for holding less liquid assets
Interaction with other premiums
- Size premium may be correlated with other risk factors (value, momentum)
- Multi-factor models attempt to disentangle the effects of various risk premiums
- Interaction effects can lead to double-counting of risk if not properly addressed
- Advanced valuation techniques consider the joint impact of multiple risk factors on expected returns
Key Terms to Review (26)
Arbitrage Pricing Theory: Arbitrage Pricing Theory (APT) is a financial model that describes the relationship between the expected return of an asset and various macroeconomic factors, allowing for the identification of arbitrage opportunities. This theory suggests that the price of an asset can be influenced by multiple risk factors, and it serves as an alternative to the Capital Asset Pricing Model (CAPM) by focusing on systematic risk. It connects to concepts like equity risk premium, size premium, and weighted average cost of capital by illustrating how these factors can impact expected returns and investment valuation.
Beta: Beta is a measure of a stock's volatility in relation to the overall market, indicating how much the stock's price moves compared to market movements. A beta greater than 1 signifies that the stock is more volatile than the market, while a beta less than 1 indicates it is less volatile. This measure is crucial for assessing risk and determining expected returns on investments, impacting various financial concepts such as free cash flow to equity, weighted average cost of capital, and risk premiums.
Capital Asset Pricing Model (CAPM): The Capital Asset Pricing Model (CAPM) is a financial model used to determine the expected return on an investment based on its systematic risk, measured by beta, and the expected return of the market. This model helps investors understand the relationship between risk and return, incorporating the equity risk premium, size premium, and company-specific risk premium as components that influence expected returns.
Equity Size Premium: The equity size premium refers to the additional return investors expect to earn from investing in smaller companies compared to larger companies. This premium is based on the belief that smaller firms tend to have higher risk due to factors like limited resources and market volatility, and thus investors require a higher return as compensation for taking on that risk.
Expected return: Expected return is the anticipated profit or loss from an investment, calculated based on the probabilities of different outcomes. It serves as a critical measure in assessing the potential rewards of an investment compared to its risks. By understanding expected return, investors can make informed decisions about where to allocate their resources, taking into account factors like market conditions and the inherent riskiness of the investment, which ties into broader concepts such as risk premiums and market behavior.
Fama-French Three-Factor Model: The Fama-French Three-Factor Model is an asset pricing model that expands on the Capital Asset Pricing Model (CAPM) by incorporating three factors to explain stock returns: market risk, size, and value. This model highlights the size premium, indicating that smaller companies tend to outperform larger companies over time, while also factoring in the value premium, which suggests that stocks with lower prices relative to their fundamentals offer higher returns.
Historical return analysis: Historical return analysis is the process of evaluating the past performance of an investment or a portfolio by examining its historical returns over a specific period. This analysis helps investors and analysts understand how different factors, such as market conditions and company size, have influenced returns, allowing for better predictions about future performance. By comparing historical returns across different investments, this method can provide insights into risk and potential rewards, including the identification of size premiums.
Ibbotson Associates: Ibbotson Associates is a well-known research firm that specializes in financial data and investment analysis, particularly in the areas of equity risk premium and size premium. Their work provides essential benchmarks for valuing investments and understanding expected returns in the stock market, making them a critical resource for finance professionals and investors.
Information Asymmetry: Information asymmetry occurs when one party in a transaction has more or better information than the other party, leading to an imbalance in the decision-making process. This can result in adverse selection and moral hazard, affecting pricing and risk assessment, particularly in financial markets and business valuations.
Investor Sentiment: Investor sentiment refers to the overall attitude and emotional outlook of investors toward a particular market or asset. It can greatly influence investment decisions, leading to fluctuations in market prices that aren't always based on fundamentals. This emotional component can drive market trends and affect the perceptions of equity risk, the valuation of small-cap companies, and the adjustments made between voting and non-voting stock.
January Effect: The January Effect is a market anomaly where stock prices, particularly those of small-cap companies, tend to rise significantly during the month of January. This phenomenon is believed to occur due to several factors, including tax-loss selling at the end of the year and the reinvestment of year-end bonuses, which can drive up demand and prices in January.
Large Cap: Large cap refers to companies with a market capitalization typically exceeding $10 billion. These companies are generally well-established, financially stable, and often dominate their industries, providing investors with a sense of security. In financial markets, large-cap stocks are considered less volatile compared to small-cap or mid-cap stocks, making them a popular choice for conservative investors seeking steady growth and dividends.
Liquidity: Liquidity refers to the ability of an asset to be quickly converted into cash without significantly affecting its value. In business valuation, understanding liquidity is crucial as it impacts a company's operational continuity and investment potential. A business that is considered liquid can meet its short-term obligations, which is essential when assessing the going concern assumption, the different levels of value in asset evaluation, the consideration of a size premium, and the analysis of balance sheets.
Market Capitalization: Market capitalization, or market cap, refers to the total market value of a company's outstanding shares of stock. It is calculated by multiplying the current share price by the total number of outstanding shares. Market cap provides a quick way to gauge a company's size and relative importance in the stock market, influencing investment decisions and valuation comparisons across companies.
Market Inefficiency: Market inefficiency occurs when asset prices do not reflect all available information, leading to mispriced securities and opportunities for arbitrage. This concept suggests that markets can fail to accurately incorporate new data or investor sentiments, which can result in prices deviating from their intrinsic values and create potential advantages for savvy investors.
Operational Efficiency: Operational efficiency refers to the ability of an organization to deliver products or services in the most cost-effective manner without compromising quality. It involves optimizing resources, processes, and systems to maximize output while minimizing waste, ultimately leading to improved profitability and competitiveness. This concept is crucial when considering how organizations can achieve a size premium through effective scaling and how an assembled workforce can enhance overall productivity.
Price-to-earnings ratio: The price-to-earnings (P/E) ratio is a financial metric that compares a company's current share price to its earnings per share (EPS), providing insight into how much investors are willing to pay for each dollar of earnings. This ratio is crucial for assessing company valuation, growth potential, and investment attractiveness, influencing various analysis methods and valuation techniques.
Risk-adjusted return models: Risk-adjusted return models are financial tools used to evaluate the performance of an investment by considering the level of risk taken to achieve that return. These models help investors understand whether they are being adequately compensated for the risks they are assuming, allowing for a more accurate comparison between different investments. By adjusting returns based on associated risks, these models play a crucial role in portfolio management and asset valuation, particularly when assessing the size premium in investment opportunities.
Rolf Banz: Rolf Banz is a prominent financial economist known for his research on the relationship between company size and stock returns, particularly the concept of the size premium. He demonstrated that smaller companies tend to outperform larger companies on a risk-adjusted basis, challenging traditional investment theories and contributing to our understanding of market efficiency.
Size premium: Size premium refers to the additional return that investors expect to earn from investing in smaller companies compared to larger companies, reflecting the higher risks associated with smaller firms. This premium is often attributed to factors such as lower liquidity, higher company-specific risk, and less market visibility for smaller companies. Understanding size premium helps investors assess expected returns in conjunction with equity risk and company-specific risks.
Size-adjusted beta: Size-adjusted beta is a financial metric that modifies the traditional beta coefficient by incorporating the size of a company to better assess its risk relative to the market. This adjustment recognizes that smaller companies tend to have higher risk and return profiles compared to larger, more established firms. By adjusting beta based on company size, investors can obtain a more accurate reflection of expected returns and risks associated with smaller stocks, connecting it directly to the concept of size premium in investing.
Small Cap: Small cap refers to companies with a relatively small market capitalization, typically defined as those with a market value between $300 million and $2 billion. These companies often have higher growth potential compared to larger firms, but they also carry increased risk and volatility due to factors like limited resources and market presence.
Small company premium: The small company premium refers to the additional return that investors require for investing in smaller companies compared to larger, more established firms. This premium compensates for the higher risks associated with smaller firms, including less market visibility, lower financial stability, and more volatile earnings. Understanding this premium is crucial for accurately assessing the value of small businesses and for making informed investment decisions.
Smb (small minus big) factor: The smb factor is a financial metric that measures the difference in returns between small-cap stocks and large-cap stocks. This concept plays a crucial role in asset pricing models and suggests that smaller companies tend to outperform larger companies over the long term, providing an additional layer of return for investors willing to take on the added risk associated with smaller firms.
Survivorship Bias: Survivorship bias is a cognitive bias that occurs when only the successful or surviving instances of a group are considered, leading to an incomplete and potentially misleading analysis. This bias can distort perceptions and conclusions by ignoring the failures or those that did not survive, which is particularly relevant in assessing investment strategies, risk premiums, and the performance of smaller companies in the market.
Systematic Risk: Systematic risk refers to the inherent risk that affects the overall market or a broad segment of the market, rather than individual securities. This type of risk is influenced by factors such as economic changes, political events, and natural disasters, making it impossible to eliminate through diversification. Understanding systematic risk is crucial as it ties into concepts like capital asset pricing, company valuations, and investor expectations about returns.