Small Firm Premiums in Valuation (article 12 of 12)

Kersten Corporate Finance is a boutique style M&A consulting firm in The Netherlands. We sell and buy "SME" and "medium size" companies for our clients. Moreover, we provide Business Valuations for all kinds of business settings. In addition, once a year (March/ April), we provide a 6 day Business Valuation & Deal Structuring training (financial modelling in excel) in The Netherlands (Vd Valk Hotel Uden).

M&A and valuations: www.kerstencf.nl

Training: www.joriskersten.nl

Article 12 of 12: Valuation: Small firm premiums

Author: Joris Kersten MSc

Source blog - Book: The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer.

Premiums and discounts

A valuator needs to take potential premiums and discounts into account.

The most common ones are:

1. Discount for a lack of marketability;

2. Premium for control;

3. Discount for small companies.

In the last article I have talked about the “discount for a lack of marketability” (1) and the “premium for control (and discount for minority shareholdings)” (2).

And the topic of this article is the “discount for small companies”.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Small company discount

A large number of studies of historical data have shown that the returns actually achieved by investing in small companies have been relatively high.

Relatively high in a sense that what would be expected by the application of CAPM (capital asset pricing model) analysis.

So it looks like investors require an additional return for the risks of investing in small companies.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Operational leverage

In practice the CAPM generally suggests that the required returns on investments in small companies are higher than of larger companies.

When we look at betas of groups of companies of different sizes, we see that the betas are higher for small companies.

A likely explanation for this is that these companies are exposed to a larger degree of “operational leverage”.

This means that the portion of fixed costs is relatively high in relation to turnover.

And this implies that the “free cash flow” fluctuates by a large portion as revenue moves up and down with the state of the economy.

But the increase in the cost of equity due to these relatively high betas can not explain the overall high returns historically achieved by small companies.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Evidence on the small company risk premium

To determine the level of a “small company risk premium” we need to look at empirical studies on the returns of small companies.

One study was done by two PWC consultants (Roger Grabowski & David King) in 1999. They looked at evidence from historical returns over the period 1963 until 1998.

They divided up the companies on the New York Stock Exchange into 25 equally sized portfolios.

This based on eight different measures of company size, like:

· Market value of common equity;

· Book value of common equity;

· Five year average net income;

· Market value of invested capital;

· Total assets;

· Five year average EBITDA;

· Sales;

· Number of employees.

To the 25 portfolios for the NYSE companies Grabowski & King added companies from the American Stock Exchange and the NASDAQ.

Herewith they increased the number of small companies in the survey.

They found that the level of equity beta is inversely related to the size of the company.

For example, companies with the largest market capitalization (average of 65 billion USD) had an average equity beta of 0.91.

And the portfolio with the smallest companies (average market cap of 44 million USD) had an average equity beta of 1.39.

Similarly, the achieved arithmetic average return over the period 1962-1998 also appears to be inversely related to firm size.

The largest firms had an average of 14.2% and the smallest firms an average of 22.9%.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Example of small firm premium according to Grabowski & King

It is clear that the higher returns (e.g. 22.9%) achieved by smaller companies are in excess of those that would be suggested by the standard CAPM.

So let’s take a look at an example:

From the Grabowski & King research we can find that the group of smallest companies ("group 25" with an average market cap of 44 million USD) had an average equity beta of 1.39.

We then combine this with a large stock equity market risk premium of 6.2% and a risk free rate for 1963-1997 of 7.6% (the figures used by Grabowski & King).

This gives an estimate of the cost of equity based on CAPM of:

7.6% + 1.39 * 6.2% = 16.2%

But the actual historical arithmetic average return for the “portfolio 25” was 22.9%.

So according to Grabowski & King 6.7% (22.9% - 16.2%) could be added to the standard CAPM calculation to a company with a (relatively) small market cap of about 44 million USD.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Thanks for reading !!

And see you next week with a new article !

Have a great week, best Joris

Source blog - Book: The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer.