Adding a size premium to the cost of equity could make an expert’s testimony subject to a Daubert challenge, says Clifford Ang (Compass Lexicon) in a recent article. If the challenge is successful, the expert’s testimony is not admissible. He points out that one of the indicators under Daubert is “whether the theory or technique in question can be (and has been) tested.” Ang says that, “with regard to the size premium, there is no theory that exists, let alone one that is testable.” He points to the groundbreaking 1981 article by Rolf Banz on the size premium that concludes that there is “no theoretical foundation for such an effect.” Plus, Ang says that adding a size premium results in an unknown error rate, which goes against another indicator mentioned in Daubert.

The article, “It’s Time for Valuation Experts to Let Go of the Size Premium,” is available if you click here (free registration required). Ang has written a number of other articles on the size effect, including “The Absence of a Size Effect Relevant to the Cost of Equity,” in the ASA’s Business Valuation Review, and “Why We Shouldn’t Add a Size Premium to the CAPM Cost of Equity,” which appeared in NACVA’s QuickRead.