Size Premium
AdvancedA size premium is the extra return that some analysts add to the cost of equity for smaller companies, based on the view that small companies are riskier and have historically earned higher returns than large ones.
Research in the 1980s found that shares of smaller companies had earned higher average returns than those of larger companies over long periods, more than their betas alone would predict. This led to the idea of a size premium.
In practice, valuers, especially of private and small companies, sometimes add a size premium to the cost of equity calculated with the Capital Asset Pricing Model. For example, an analyst might add 2% to the cost of equity for a small private manufacturer, reflecting risks such as dependence on a few customers or key people, limited access to finance and less diversified operations.
The size premium is controversial. Later research found that the effect weakened after it was widely publicised, varied greatly between periods and may partly reflect other factors, such as illiquidity or poor quality among the smallest companies.
Some valuers prefer to address the specific risks of small companies directly in cash flow forecasts. Whatever approach is used, the assumptions should be explained clearly.
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