“I have never used a small cap premium when valuing a company and I don’t plan to start now,” states Professor Aswath Damodaran (New York University Stern School of Business) in his latest blog post. He re-examines relevant data and discusses the long-standing arguments for adding a size premium to the discount rate for small firms.
Triple whammy: He cites three reasons why he doesn’t use a size premium: (1) the historical data are yielding more ambiguous results, which call into serious question whether a size premium exists; (2) forward-looking risk premiums are yielding no premiums for small-cap stocks; and (3) if based on intuition (that smaller firms are riskier than larger firms), much of the extra risk can either be diversified away, better treated as an adjustment to expected cash flows, or it’s double counted.
He also makes the point that “inertia” is another culprit. Some analysts add a size premium by rote because that’s the way it’s always been done. And he points out that the custom is reinforced by the legal system that looks to precedence as opposed to what may be a better practice. Damodaran made this same point in an interview in Business Valuation Update (September 2014) when he said: “For better or worse, you can have bad valuations that are legally defensible and good ones that are not.”
Comments: “I would highly recommend that all appraisers read Professor Damodaran’s take on the small stock premium,” Bob Dohmeyer (Dohmeyer Valuation Corp.) tells BVWire. “It contains very insightful commentary along with a beautifully nuanced analysis and coherent conclusion based on all of the available empirical data. Whether or not you personally agree with his findings, all appraisers should read this in order to be prepared for possible critiques. The thought of being open-minded is also important and we should keep that in mind.”
“I think Professor Damodaran asks some bluntly honest questions that few have the courage or knowledge to address,” says Michael A. Crain (The Financial Valuation Group). “Perhaps BV has reached a time to seriously assess some of its practices as Wall Street and regulators did on standard finance practice after the financial crisis of 2008 and 2009. This kind of discussion reminds me of a Harvard Business Review article that I read about 10 years ago by Emanuel Derman, a Ph.D. and former quant on Wall Street. He writes that modern economists tend to explain things with math even though, on average, the world is too complex for that. Contemporary finance (financial economics) research and practice tends to be part of this math phenomena.”
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