Does Size Still Matter in Valuation?

For decades, valuation analysts have incorporated a “size premium” when calculating the cost of capital in their valuation engagements. A paper by Rolf Banz first documented the size effect in a 1981. Simply put, the theory asserts smaller companies have greater risks and therefore have a higher cost of capital.

The size premium has been the subject of much valuation research and many papers over the years, with compelling arguments made by industry luminaries on both sides of the issue. Recently, NYU professor Aswath Damodaran, known as the “dean of valuation,” opined that the size premium had “been gone for 40 years,” and advised analysts at a recent CFA Institute conference to “just let it go.”

Another well regarded valuation analyst, Clifford S. Ang, agreed, suggesting that the “evidence shows that there is no theoretical foundation for the size premium.” He further suggests that the size premium does not distinguish between the risks faced by a “young small company” and an “old small company” and that using the size premium might even put an expert’s testimony at risk for a Daubert challenge.

Of course, other industry sages dispute these ideas, including valuation authority Roger Grabowski, who claims Ang’s analysis is misleading. Also, the widely used Annual Pepperdine Private Capital Market Report has consistently demonstrated the existence of a size premium.

Although an academic consensus does not exist, a recent Business Valuation Update webinar poll showed that about 94 percent of the valuation practitioners in the audience use a size premium in their valuations. Moreover, valuation credentialing organizations generally teach practitioners to add a size premium to the equity risk premium (ERP).

As with all topics in the valuation arena, this one will continue to garner interest and inspire debate. Stay tuned for updates.

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