Are small companies more risky than large companies? In a qualitative sense, the answer to this question is usually yes. Small companies, whether publicly traded or privately held, are generally believed to have more risk than larger companies due to limited capital resources (financial, intellectual and/or human). Financial theory tells us that higher levels of risk translate into higher levels of required return. In other words, investors or owners want to be compensated in the form of a higher return on their investment for taking on higher levels of risk. This positive differential in required return on small companies versus large companies is commonly referred to as the “size premium”. This premium is differentiated from the company-specific risk premium, which is a separate component of the discount rate intended to quantify risk associated with issues specific to the company being valued. Generally accepted methodologies for the development of discount rates for private companies typically include both of these premiums.
The existence of the size premium has historically been accepted as fact in the business valuation community, resulting in higher discount rates applied to small companies versus otherwise similar large companies. The empirical data used to quantify the size premium measures rate of return differentials in the public equity market going back to 1932. However, portions of the academic and practitioner communities have called into question the continued existence of the size premium. The support for this position typically revolves around an examination of more recent return data, eliminating older data that may no longer be representative of current conditions. In particular, studies that have focused on return data since the early 1980’s indicate little or no difference in the rate of return earned on small versus large stocks. The early 1980’s coincides with the growth in popularity of mutual funds focusing on certain sectors or segments of the stock market. As demand for small stocks increased due to small stock-focused mutual funds growing in the marketplace, rates of return seem to have been driven downward to a point of statistical equality with large stock returns. The debate rages on, though the majority of the valuation community continues to subscribe to the traditional theory that small stocks deserve a premium in required return over large stocks.
Rate of return data presented in a recent market summary produced by The Milestone Group for the first quarter of 2019 caught my eye because of the previously-described debate over the size premium. The chart included in this summary showed rates of return on various segments of the equity and debt markets, both domestically and internationally. Returns were shown for three different time periods: 1) first quarter of 2019; 2) the past year; and 3) the past 10 years (annualized). The return data for U.S. markets is summarized in the following table:
While returns in the first quarter were similar, data for the past year and the past 10 years shows returns on large stocks exceeded returns on small stocks. This is the opposite of what we would expect to see based on the size premium concept. If small company stocks carry a higher level of risk, but large company stocks earn an out sized return, the compensation we would expect investors to demand for bearing additional risk does not appear to be present.
While we would not point to this observation as conclusive evidence against the size premium, it is interesting in light of the ongoing debate.
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