The Size Premium (Beta Adjusted) is the historical size premium adjusted for the decile beta over the selected time period. This is notably the case in North America. However, given that our focus in this post is on the size premium measured as a delta, consistency is more important than precision. Whilst I agree that there is limited logic for a small cap premium, WACCs do appear lower for smaller cap stocks, even when adjusting for the higher marginal after tax cost of debt. The aggregate equity premium is typically broken into two pieces: (1) a market risk premium, and (2) a size premium. If the justification is intuitive, i.e., that smaller firms are riskier than larger firms, much of that additional risk is either diversifiable, better adjusted for in the expected cash flows (instead of the discount rate) or double counted. Further there is the migration effect i.e. To estimate the mature market risk premium, one has to compute the implied equity risk premium for the S&P 500 index. The small-capitalization stocks premium (size effect) is one of the few effects which is accepted by nearly the whole academic community. It says that low capitalization stocks earn substantial premiums against stocks with large capitalization (without additional risk). The aggregate equity premium is typically broken into two pieces: (1) a market risk premium, and (2) a size premium. Different estimates regarding the risk-free rate, market risk premium, size premium, specific-company risk, cost of debt, tax rate, and capital structure can result in significantly different estimates of the WACC. I have argued that lack of diversification effectively scales up your exposure to conventional market risk. Während es die Menschen zunehmend in die Städte zieht und der Wohnraum stetig knapper und teurer wird, steigt gleichzeitig das Bedürfnis nach Lebensqualität. Over the long-haul they seem to have had higher returns and are potentially lower risk being larger and more established than their smaller cap counterparts. Industry risk premium sourced from SBBI Valuation Essentials handbook 6. The Financial Reporting Blog is updated weekly. You can view the latest equity market risk premium here. The common formula for the build-up model (“BUM”) to estimate the cost of equity capital is We consider government securities to be risk-free assets. JWBT309_Web_Add-6.qxd 02/04/2011 7:10 PM Page 4 Aptara. UniverseofRisks,You have a good point, though the growth rate you use can only be marginally higher than the growth rate of the economy, since it is a perpetual number. Given the iterative relationship between capital structure and the cost of the individual components, such an emphasis would also lend some stability to the analysis. The magnitude of the equity risk premium, or required return in excess of the risk-free rate, is a perennial question for valuation specialists. The traditional method for measuring return premiums is backward-looking. Title: At least one could argue this part of the equation has some validity but it is a non-priced excess return on a current basis for most microcaps. By the take same token, I should probably use a slightly lower than the economy growth rate for larger companies. I understand your blog and I agree with your arguments. The Fama-French model aims to describe stock returns through three factors: (1) market risk, (2) the outperformance of small-cap companies relative to large-cap companies, and (3) the outperformance of high book-to-market value companies I think its a very important topic. Second, the Compustat (and to a much less extent CRSP) data has two biases associated with construction of the combined data: a backfilling bias (as the databases were constructed and filled in over time from the 1970s to current with subsequently successful companies "backfilled" and added to the historical data overtime) and a restatement bias (historic data was restated after mergers or subsequent restatements). The government would, theoretically, never default on the interest and principal payments of its securities. The resulting differences provide a measure of the size premium applicable to lower middle market companies (at the level of the WACC). A Do-it-yourself (DIY) Valuation of Tesla: Of Investment Regrets and Disagreements! Country risk premium sourced from Prof. Damodaran’s research based on sovereign credit rating by Moody’s 5. According to Aswath Damodaran, to estimate the equity risk premium for a country, one should find the premium for a mature market and add an additional country risk premium, based upon the risk of the country in question. WACC Expert - Calculate your WACC in a few clicks : choose your country, your sector, adjust the parameters, get an excel file and order a report ! I once had a discussion with you at a CFA Valuation Conference about when cash flow riskiness should be reflected in the cash flow estimate, rather than discount rate, and you talk about that again here. Realized returns from smaller stocks are not consistently greater than those from larger stocks. I have never used a small cap premium, when valuing a company and I don’t plan to start now. A Skeptical Look at ESG. Playing with the IFA index calculator it seems like small almost always outperforms large:https://www.ifa.com/calculator/?i=sv&g=100000&s=1/1/2000&e=1/31/2014&infl=true&af=true&aorw=false&perc=trueAlso see:http://www.marketwatch.com/story/the-one-asset-class-every-investor-needs-2014-06-25BR Martin. In the end, reasoned judgment is more important than technique. Yogesh,It it takes this much convoluted back tracking for you to try to explain with small cap stocks, there is no small cap effect. Small Cap Premium according to KPMG Australia 2017. Second, we infer WACCs on lower middle market private companies using aggregate transaction data from GF Data. It is also possible that the GF Data – like all transaction data sets – is subject to a selection bias, as it includes data only on companies that actually transacted. Since forward earnings estimates, capital expenditure, and working capital data for the companies in the GF Data set are not available, we assume that the relevant performance measures for the corresponding public company groups are applicable to the private companies. If it is intuitive, i.e., that small companies are riskier and markets must see them as such, I don't see the basis for the intuition, since the implied costs of equity for small companies are no higher than those of large companies. 2. • Stocks: Size, Value, Momentum Liquidity premiums in public equity markets • As substantial as, and different from size, value, momentum • Liquidity, like risk, should be managed to produce returns 22. In practice, I have noted that a number of the stocks I am reviewing in the UK that are listed below the FTSE100 have lower equity betas (and asset betas) than direct comparables. For decades, analysts and investor have bought into the idea of a small cap premium, i.e., that stocks with low market capitalizations can be expected to earn higher returns than stocks with higher market capitalizations. there was a size premium of 3.4% per annum in the United States. In addition to transaction multiples, GF Data publishes very useful data on capital structure and financial costs. In other words when we look at decile 10 of the capitalization strata, the character of the firms in the decile 10 is vastly different every year. When we talk about January effect, we're in effect talking about a 12 month reversal phenomenon. Common sense tells us there is a difference between a multi-million dollar corporation and a small main street shop. Analysts typically compare realized returns for various asset classes over long historical periods, inferring the premiums from the differences in the return series. The Storming of the Bastille: The Reddit Crowd targets the Hedge Funds! In contrast with standard risk premiums, size-based portfolios are found by the authors to be virtually unskewed. In seinem prämierten Architekturkonzept widmet sich Michael Sieger dem modernen Premiumbad im Spiegel gesellschaftlicher Trends. The 2016 Valuation Handbook – Cost of Capital (Exhibit B-1), based on historical risk premium average since 1963 for a portfolio of average market value of $148 million, calculated a Size Premium over CAPM of 11,24% and a Smoothed Size Premium over CAPM of 6,41%, data smoothing with regression analysis: Smoothed Size Premium = 11,780% – … 4 Impairment Test 52. Ones that are small and fast growing now,which will be replaced by newer and younger companies in the future. So splitting the sample period (1926-2014) into three periods of bull markets, bear markets and range bound markets would give us some more insights on the small cap premium. Whether the reported growth rates are sustainable with “normal” levels of capital investment is unknowable. For the overall index, the median performance measures and EBITDA multiple imply a WACC of 8.1%. Put simply, if small cap stocks are viewed by investors as riskier and that risk is being priced in, you should expect to see, other things remaining equal, higher expected returns on small cap stocks than large cap stocks. In effect, to the extent that my base year cash flows are reasonable and my expected growth rate reflects market expectations, the expected return on large cap stocks on January 1, 2015 was 7.95% in the US (yielding an overall equity risk premium of 5.78% on that day). (The outlier valuation multiple and implied WACC for the Media & Telecom subgroup is perhaps explainable by the woes besetting the news publishing and TV/radio broadcasting businesses.). Given the reality of typically poor diversification in small business valuation, is any premium warranted for the owner's inability to diversify systematic risk? These "outliers" have been shown to significantly explain some of the "anomalies" in some of the academic research. Data Update 1 for 2021: A (Data) Look Back at a Most Forgettable Year (2020)! By using the same rate as the S&P 500 you're actually calculating the return on equity of companies that begin as small cap but are treated as large caps after year 5. The traditional build-up computation of the WACC is subject to a host of variables that can have a material impact on the overall conclusion of the WACC. It says that low capitalization stocks earn substantial premiums against stocks with large capitalization (without additional risk). Thanks for a great piece, Professor. GF Data collects and publishes transaction information from approximately 250 private equity groups on a blind and confidential basis. Certain Delaware Chancery Court decisions involving a size premium discussion. Travis’s practice focuses on providing financial education, valuation, and other strategic financial consulting to multi-generation family businesses. The signal from realized returns is directionally opposite to changes in the relevant premiums. You can subscribe here. Using a basic five-period discounted cash flow model, we then calculate the implied WACC for each industry grouping. For example, distribution companies have the lowest margins, and manufacturing companies carry relatively large amounts of working capital. The small stock premium is the concept of increasing the discount rate, to make specific allowance for the relative size of the entity being valued, by reference to size data from the public markets. Analysts typically compare realized returns for various asset classes over long historical periods, inferring the premiums from the differences in the return series. 3. Our procedure is straightforward. Consider the following example. The relevant discount rate for measuring enterprise value is the weighted average cost of capital, not the equity discount rate. Exhibit 4 illustrates the application of the model for the overall group. If the argument is that everyone does it, I am sorry but just because something is established practice does not make it right. Professor Aswath Damodaran has advocated a similar approach for estimating the equity risk premium for public companies. The Price-Value Feedback Loop: A Look at GME and AMC! I do think that there is a glimmer of hope in the recent research that the payoff to looking for under valued stocks may be greater with small companies, partly because they are more likely to be overlooked, but it will take more work on your part and it won't be easy! The Sharing Economy come home: The IPO of Airbnb! That discount rate is used to estimate the value of future cash flows, and not surprisingly, the use of a small cap premium lowers the value of smaller companies. Liquidity issues that may account for the size premium 5. During period 1, the risk premium increased, yet the marginal impact of period 1 is to reduce the risk premium when calculated on the basis of realized returns. In fact, small companies should disappear from the market. As expected, the observed capital structures at acquisition use more financial leverage than the typical public company. Using the relevant cash flow measures from Exhibit 3, the implied WACC is the discount rate at which the indicated enterprise value conforms to the forward EBITDA multiple. (I concocted the total beta measure to capture it).Michael,I think that the bulk of the premium, if it exists in microcap companies is a reflection of either survival risk or illiquidity and my points about double counting still stand. The R2K has underperformed small caps in general. Dear Professor Damodaran,Thank you for addressing this topic and in advance for consideration of my question. Even the most favorable papers on the small cap premium suggest that you have to add refinements, with some suggesting that these refinements should screen out the least liquid, riskiest small cap stocks and others arguing for value characteristics (stable earnings, high returns on equity & capital, solid growth). In other words(dogs of the Dow theory), the losers of the preceding year outperform the winners of the preceding year and quite understandably so, the micro cap firms whose market cap had plummeted in the preceding 12 months would be expected to outperform the broad market. In estimating implied ERP for small cap you have used dividend discount model (for stable firms), is this model right in the first place for small companies which are typically 1) growing and 2) not stable?However, I agree with you that small cap premium is actually not warranted since we have to estimate cash flows based on the characteristics of a particular small firm, and discount rate should not capture it. In the CAPM framework to estimate the cost of equity, when a decile beta is greater than 1.0, beta absorbs some of the Size Premium (S&P 500), where the benchmark S&P 500 has a beta of 1.0. Securities transactions conducted through StillPoint Capital, Member FINRA/SIPC, Tampa, FL. The forward-looking risk premiums, where we look at the market pricing of stocks to get a measure of what investors are demanding as expected returns, are yielding no premiums for small cap stocks. Travis W. Harms leads Mercer Capital’s Family Business Advisory Services Group. This is the strongest (and perhaps) only evidence for a small cap premium and it is reproduced in data services that try to estimate historical risk premiums (Ibbotson, Duff and Phelps etc.). It's been gone for 40 … The U.S. size premium is statistically significant (with a p-value of 1.7%), assuming the returns are normally distributed. The traditional method for measuring return premiums is backward-looking. However, the middle market and lower middle market companies that business appraisers value are often smaller than small cap public companies. Data Update 3 for 2021: Currencies, Commodities, Collectibles and Cryptos. My only concern is; intuitively when you're computing the Implied ERP for small cap stocks, you are looking at a cash-flows of a dynamic set of companies. Risk premiums are measured on an equity basis. Size: Premium : Market cap USD 1,001m < 0.0%: … The industry groupings were made to promote comparability to GF Data industry measures. If it is that they have a greater chance of failure, I will estimate a probability of failure and reflect that in my expected value (. Stefano Ciliberti , Emmanuel Sérié , Guillaume Simon , Yves Lempérière , Jean-Philippe Bouchaud The Journal of Portfolio Management Jun 2019, 45 (5) 58-68; DOI: 10.3905/jpm.2019.1.086 The size effect in finance literature refers to the observation that smaller firms have higher returns than larger firms, on average over long horizons. In this market, finding an under valued stock is tough enough. In the decades since the original small cap premium study, the data on stocks has become richer and deeper, allowing us to take a closer look at the phenomenon. In addition to the industry breakdowns, GF Data segregates the universe of observed transactions by size. Thus Angola has a CRP of 25.77% and a total equity risk premium of 31.78% (22.14% + 6.01%). To get a measure of the forward-looking small cap premium, I computed the. In the CAPM framework to estimate the cost of equity, when a decile beta is greater than 1.0, beta absorbs some of the Size Premium (S&P 500), where the benchmark S&P 500 has a beta of 1.0. There are some serious questions that can be raised about whether the premium exists and if so, what exactly it is measuring: If the historical data ceases to support the use of a historical risk premium, can we then draw on intuition and argue that since small companies tend to be riskier (or we perceive them to be), investors must require higher return when they invest in them? risk premium – Other risk premiums – Sustainable growth rate ’14 – Detailed analyses for every industry – Consideration of risk in the derivation of cash flows – Risk equivalence in determining the cost of capital – Small cap premium – Debt beta: Sharing of risk between financiers ’15 – Study layout in tablet-friendly You can, but the onus is then on you to back up that intuition. Aswath Damodaran had a spate teaching at the University of California, Berkeley, from 1984 to 1986, where he received the Earl Cheit Outstanding Teaching Award in 1985. We next calculate the implied WACC for lower middle market companies (transaction values between $10 million and $250 million) based on transactional data compiled by GF Data. It can borrow from the central bank or print more currency. The Size Premium in Equity Markets: Where Is the Risk? For your reference, you can compare this number with the implied equity risk premium published by Damodaran on his website at any time (5.77% for March 2020). As a result, business appraisers would probably do well to consider the impact of size on the overall WACC rather than on a single component of the capital structure. To illustrate how distorted this debate has become, note that those who routinely add small cap premiums to their discount rates are not put to the same test of justifying its use. Again, these are size premiums relative to the WACC, not the cost of equity. Observations of the CRSP Size Premium 10th Decile Category. But even the academic studies often do not use this corrected data (because it does not come automatically matched up with the CRSP data, requires a separate purchase, and the data only goes back to 1983). Needless to say, I am often asked to justify my non-use of a premium and here are my reasons. Further, available trailing twelve month revenue growth rates and EBITDA margins reported by GF Data are generally higher (revenue growth often in the mid-teens and margins in excess of 20%). The return on a 10-year government bond is 7%, the beta of security A is 2, and the market return is 12%. For the smallest companies (below about $500 million in market cap), DCF technicians may add a "size premium" of 2-4% to the company's WACC to account for the additional risk. Applying the same procedure to this data yields additional color regarding the size premiums applicable to lower middle market companies, as summarized in Exhibit 7 below. In fact, you can check to see whether investors are demanding a forward looking "small cap" premium, by looking at how they price small as opposed to large companies, and backing out what investors are demanding as expected returns. • The size premium study presented earlier in this chapter [across all indus-tries] provides more reliable statistics as they relate to the size premium.6 4 FINANCIAL VALUATION 6 Ibid., 153–155. Small size risk premium과 비유동성(illiquidity) premium에 대해 살펴봤는데요 이 두가지 프리미엄은 WACC을 구하는 이론적 모델이 충분하게 반영할 수 없는 현실적인 제약요건에 기인하는 것으로 평가대상의 경제적상황, 평가목적, 정보이용자 등을 종합적으로 고려하여 전문가적 판단에 따른 적용이 필요합니다. 1.2.4 L’equity risk premium! Small Size Premium Spa. Since the existing capital structure is replaced in its entirety in nearly all private company transactions, buyers and sellers think about enterprise value, not the value of equity in the seller’s capital structure. In this post, we summarize an “ex ante” analysis of the size premium applicable in measuring the WACCs for lower middle market companies. In corporate finance, it is the hurdle rate on investments, an optimizing tool for capital structure and a divining rod for dividends. This is notably the case in North America. If you are following a strategy of buying small cap stocks, expecting to be rewarded with a premium for just doing that, you will be disappointed. One of the most pressing questions that keeps coming up in business appraisals is the difference between values of companies of different sizes. While the lower middle market capital structures may be expected to moderate over time, the capital structure discrepancy ultimately confirms the decision to focus on the WACC, rather than the cost of individual components, each of which will vary with leverage levels. rate, equity risk premiums, size premiums, other risk measures); and co-author of the annual Valuation Handbooks: U.S. Industry Cost of Capital; International Guide to Cost of Capital; and International Industry Cost of Capital (Duff & Phelps, 2018). The analysis summarized in this post is not intended as a technique for calculating the weighted average cost of capital. We also present an overview of our analysis and conclusions regarding an appropriate equity market risk premium to be applied as per 31 December 2020. To illustrate, consider a practice in valuation, where analysts are trained to add a small cap premium to discount rates for smaller companies, on the intuition that they are riskier than larger companies. In fact, they report that the extreme risk of these portfolios is dominated by the large-cap leg; small caps actually have a positive (rather than negative) skewness. Would it be more precise to use the small implied premium? My not-so-profound thoughts about valuation, corporate finance and the news of the day! Since almost all of the "excess returns" disappeared on this comparison, it was only a matter of time before index funds entered the arena, creating small-cap index funds for investors who wanted to claim the premium, without paying large management fees. The NAESX has actually underperformed S&P 500 funds since the end of 1986 on a geometric return basis. premia (e.g., equity risk premia, risk-free rates, size premia, industry risk premia, betas, industry multiples and other statistics) for use in valuation models. There are a number of problems that have never really been addressed with the return data and methods commonly used to estimate small cap premiums (particularly Duff& Phelps and Fama-French data): First, the use of arithmetric average returns over relatively short holding periods will mathematically always overstate the correct size premium for a three to five year DCF and for the terminal value discount rate. This is encouraging, as it indicates that variation in company-specific attributes that affect cash flow exerts greater influence over valuation multiples than variation in the WACC. Wouldn't you want your inputs for calculations beyond year 5 to reflect a constant rate of growth for small caps, which to me is much higher than the risk free rate? (T Bond rate was 4.25% at the time; 4% is the equity risk premium) Aswath Damodaran 137. Size: Premium: Market cap USD 1,400m < 0.00%: Market cap USD 845m-USD 1,400m +1.6%: Market cap USD 449m-USD 844m +2.0%: Market cap USD 210m-USD 448m +2.5%: Market cap USD 109m-USD 209m +4.0%: Source: No direct source link available, but can be found on page 13 here. Although business appraisers tend to apply size premiums consistently without regard to current market dynamics, there are periods when large-cap stocks deliver higher returns than small-cap names. Damodaran assumes the risk premium for a mature equity market at 5.23% (as of July 1, 2020). In effect, the market is attaching a smaller expected return for small cap stocks than large ones, stories and intuition notwithstanding. In a chapter to an update to a valuation text in 1998, Hakala (me) and Bajaj found no forward-looking small stock premium, found small stock premiums largely disappeared after 1980, and found that the small stock premium was highly correlated with the bid-ask spread (transactions cost) which has gone done steadily over time. Second, I do believe that small cap companies are more exposed to some risks than large cap companies but there are other more effective devices to bring these risks into valuation. Perhaps because membership in a major index grants a stock improved liquidity). The Bitcoin Boom: Asset, Currency, Commodity or Collectible? Duplicating your math, I can justify a premium of about 1.25% if I assume 10% growth in small caps for 10 years (vice 5), and then capitalize at the risk free rate. It's worse when you look at the performance of the most widely used small cap index, the Russell 2000. Forecasting size premium for small company valuation. The implied WACCs and corresponding size premiums are summarized in Exhibit 6. As of December 31, 2016, the risk premium related to the companies comprising the 10th decile was 5.59 percent. If it is that they are capital constrained (i.e., that it is more difficult for small companies to raise new capital), I will limit their reinvestment and expected growth (thus lowering value). 22 Risk in the DCF Model Risk Adjusted Cost of equity Risk free rate in the currency of analysis Relative risk of company/equity in questiion Equity Risk Premium required for average risk equity = + X Aswath Damodaran 22. Thus, much of the findings appear to be data mining and biases (arithmetric annual returns in Ibbotson and Duff & Phelps; monthly average returns in Fama-French work) and to have largely declined to not being statistically significant post 1980. While we are comfortable with the overall reasonableness of these assumptions, others are certainly possible. The 1999–2013 Ibbotson Associates/Morningstar size premia, industry risk premia, and other valuation data that are presented within the Cost of Capital Navigator are used with permission from Morningstar, Inc. There was work done for Compustat on this issue by Northfield around 2000-2001 that found substantially inflated return averages (as much as 6% overstatement of returns in 1980s) using backfilled and restated data as compared with the originally "as reported" data. Companies - Market Capitalization Risk Premium Report –Size Study: 1963 –2017, 1980 –2017 Certain members of Mercer Capital are Registered Representatives of the broker dealer StillPoint Capital, LLC. ... (and risk premiums) and ending with the a look at market pricing multiples at the end of 2017. 1) Small size risk premium 아직 우리나라에서 Valuation시 Small size risk premium 적용하는 것이 다소 생소하지만, 해외에서는 Small size risk premium … Private company valuation can sometimes be amorphous due to the lack of data transparency. Size premiums have “historically been calculated by comparing realised returns on small public company stocks to those on large company stocks. Then, the equity risk premium according to the CAPM method is as follows: β a (R m – R f) = 2(12% – 7%) = 10% . This has become deeply embedded in parts of the business valuation community. Since, he has been awarded the Stern School of Business Excellence in Teaching Award in 1988, 1991, 1992, 1999, 2001, 2007 and 2008, and was the youngest winner of the University-wide Distinguished … In addition, the growth, margin, and other assumptions must be appropriate to the subject. 4.1 Trigger and Results 53 4.2 Determination of the Recoverable Amount 54 4.3 Plausibility 56 As expected, within the lower middle market universe, valuation multiples are positively related to size, with the average EBITDA multiple on $100 million to $250 million transactions (8.9x) exceeding that on $10 million to $25 million transactions (6.0x).