In the upcoming fifth edition of their essential book, Cost of Capital: Applications and Examples, Shannon Pratt, FASA (Shannon Pratt Valuations), and Roger Grabowski, FASA (Duff & Phelps), reveal new analysis that examines the existence of the size premium.
Background. A company’s size is one of the most important elements of risk to consider when developing cost of equity estimates for valuation purposes. Over the long haul, small company stocks have proved to be riskier than large company stocks. This makes sense because larger companies have certain advantages over smaller companies. Therefore, investors require a greater return on investment in small companies to compensate for that risk. This is what the size premium is about, and it can have a material effect on the discount rate—and therefore a significant effect on the valuation of a company.
Over the years, many researchers have investigated the size effect and reached different conclusions. Ibbotson Associates measures the small stock premium using data that go back to 1926. Fama-French’s study of “small-minus-big” (SMB) returns over five different periods suggested that the evidence for a size effect is “weak.” Not long ago, small company stocks were providing lower overall returns than large company stocks. In light of all this, the existence of the size effect has been challenged, and it has even become an issue with some courts and the IRS.
Has the size premium indeed vanished?
Still kicking. “We see that the size premium is still alive and well,” said Grabowski, speaking at the recent ASA Advanced Business Valuation Conference. “Size, when size is measured by five-year average net income, is still a very important risk premium.” The exhibit shows the size effect from recent periods: 1963-2012 and also 1990-2012.
Acknowledging research that has questioned the existence of the size premium (the Banz paper of 1981 was the first to question the size premium), Pratt and Grabowski delved deep into the issue. “We expanded the analysis and we looked at all kinds of permutations from every period of time,” Grabowski says. “That is, how often do small companies earn a higher rate of return than big companies? That’s really the essence of the size premium.” They came up with statistics that show that, even with 10-year holding periods during 2000-2012, every month small companies had higher returns than big companies. “This is the most extensive analysis of data—not just a summary of other peoples’ studies but actual data—to help you understand and explain what goes on with the size premium,” he says.
Of course, the size premium will vary and may even be negative when measured over certain periods. But as the new Pratt and Grabowski analysis shows, small stocks on average over time do outperform large stocks because of their greater risks, which means that an adjustment for size is indeed appropriate.