What is size premium? How size premium affect …

1 What is size premium ? How size premium affect the valuation ? hen evaluating the value of a company or business, equity analysts or valuers often apply a size premium in the cash flow analysis. Well what is size premium and how is it determined? Today, we are going to introduce and discuss on size premium . size premium refers to the additional premium that smaller sized company need in order to attract investors. Empirical studies have shown that as size of company decrease, the risk associated with the company increases. Hence it follows the golden rule in finance that high risk comes with high return.

2 Most research on size premium are performed on the market. With reference to the method according to the Center for Research in Security Prices (CRSP), the size is determined by divide companies into deciles. It becomes one of the more common measures for ranking companies into these categories by market capitalization. One of a famous work for size premium is done by Ibbotson Associates, a leading consultant on asset allocation. Each decile based on value-weighted decile portfolios by stocks traded on the New York Stock Exchange, American Stock Exchange, and the Nasdaq National Market created by CRSP.

3 According to Ibbotson Associates, the bottom quintiles of capitalization ( deciles 9-10) are considered as micro-cap companies, which considered as small companies normally. size premium can be applied in different financial model, such as build-up model, capital asset pricing model (CAPM) and Fama-French Three Factor Model. One of the most common methods is to add a size premium to CAPM in discounting cash flows analysis. The SBBI Yearbook size premia based on the excess return CAPM is widely used. Given the decile s beta and equity risk premium of the market, the expected return is determined by CAPM.

4 As small size -decile portfolios usually have higher betas, the size premium is the return above these higher betas predicted. Beta-adjusted size premium is appropriate to apply in business valuation . It accounts for return due to size and reduces the possibility of double counting other premia. In the past few years, size premium commonly adopted by practitioners for low-cap companies and micro-cap companies are as follows: Deciles size premium # Decile 6 Decile 7 Low-Cap Decile 8 Decile 9 Micro-Cap Decile 10 + Sourced from Ibbotson SBBI valuation Yearbook 2009 2012 Asset valuation Bulletin Corporate valuation & Advisory June 2013 W