More concern about the validity of the size premium factor

BVWire–UKIssue #16-1
July 7, 2020

cost of capital
discount rate, private company valuation, risk analysis, size premium, cost of equity, size effect

Most business valuers consider a size premium when calculating cost of capital for financial reporting purposes. It’s a key element of buildup method analyses in the Duff & Phelps Navigator and in other sources. Since the ‘famous’ Rolf Banz article in 1981, however, the idea that smaller firms demand higher returns has been questioned.

A new publication in the US legal website Law360 summarises the finance research since Banz’s article and argues that this practice should end. In ‘It’s Time for Valuation Experts to Let Go of the Size Premium,’ Clifford Ang (a senior vice president at Compass Lexecon) reconfirms the fact that, from 1982, immediately after Banz’s article, until the end of 2019, small stocks did not outperform larger stocks (that fact has accelerated during the rush to big stocks driving the FTSE now). Ang uses the value-weighted portfolio returns data from Dr. French’s decile size portfolio.

Ang is not the first analyst to make this point (he quotes Damodaran, speaking at the most recent CFA Institute annual conference, to the same effect). The changing returns profile of the major markets since the 1980s is one of the key reasons analysts can choose custom start years when doing cost of capital analyses in BVR’s Cost of Capital Pro. Ang argues that, lacking theory and statistical support, size premia should only be applied in a ‘facts and circumstances’ manner. 

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