Size effect, ERP analyzed in landmark book on cost of capital

BVWireIssue #140-2
May 14, 2014

What has 1,300 pages of text, 26 pages of bibliography, 14 pages of data resources, and 40 pages of index? It’s the newly arrived Cost of Capital: Applications and Examples by Roger Grabowski (Duff & Phelps) and Shannon Pratt (Shannon Pratt Valuations Inc.), now in its fifth edition. Two interesting issues among the many covered are the size effect and equity risk premium.

Size effect is alive and well: Acknowledging research that has questioned the existence of the size premium, Pratt and Grabowski delve deep into the issue. They expand the analysis and look at permutations from every period of time. The essence of the size premium is how often small companies earn a higher rate of return than large ones. The authors came up with statistics indicating that, even with 10-year holding periods during 2000-2012, every month showed small companies with returns higher than big companies. This extensive analysis of data—not just a summary of other people's studies—helps explain what goes on with the size premium.

Of course, the size premium will waver and may even be negative when measured over certain periods of time. But, as the new Pratt and Grabowski analysis shows, small stocks on average over time outperform large stocks because of their greater risks, which means that an adjustment for size is indeed appropriate.

ERP conclusions: “Roger and I present summaries of a great deal of research on the equity risk premium (ERP),” says Pratt, writing in the ASA BV Success E-Letter. They conclude that the long-term (unconditional) ERP is between 3.5% and 6.0% on an arithmetic average basis relative to long-term (20-year) U.S. government bonds. Also, they concluded that the “conditional” (reflecting current economic and market conditions) ERP was 5.0% as the book went to press, and it remains the same today, according to Pratt.

BVWire applauds Pratt and Grabowski for their monumental work. For more details on this book, click here.

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