We explain the background, controversies and effects of risk premiums in the valuation of SMEs.
In valuation practice, it is sometimes common practice to postulate an increased risk for small and medium-sized companies and to take this into account via an additional risk premium, a so-called "size premium". The empirical foundation of the "size premium" goes back to the work of French & Fama in the early 1990s, among others. This article explains the background to the "size premium" and discusses its significance for business valuation practice.
The "size effect" describes the empirical observation that publicly traded companies with a comparatively low market capitalization, so-called small caps, achieve a higher return than companies with a comparatively high market capitalization. This effect was first observed by Banz (1981) for the US stock market. Chan & Chen (1991) and Fama & French (1993) also came to the same conclusion. Later work by Zhang (1995) and van Dijk (2011) also confirmed yield premiums for smaller publicly traded companies. The aforementioned studies differ fundamentally in their attempts to explain the "size effect". What these studies have in common is that there are comparatively higher structural risks for smaller publicly traded companies, which lead investors to expect higher returns in the form of an additional risk premium.
The empirical evidence of the size premium triggered a controversial academic debate. The subject of the discussion was and is regularly that at least the CAPM as a market equilibrium model does not provide for a size-dependent risk premium to explain the expected returns and that this also does not appear to be integrable into the CAPM model world. Systematic risk is relevant to valuation in the sense of the CAPM and therefore the only company-specific factor influencing the level of a company's expected return.
In the CAPM, this systematic risk is derived endogenously as a result of the behavior of all market participants, but is not explicitly named in terms of content. In their study, Fama/French only use a purely empirically-based three-factor model in the sense of arbitrage pricing theory (Ross 1962) with specified factors. Fama/French's approach differs fundamentally from the establishment of a theoretically based market equilibrium model to explain the return expectations of rational investors on an efficient capital markets.
The use of purely empirically based models, which also applies to the aforementioned Fama/French model, ultimately opens the door to a high degree of arbitrariness in the use and determination of premiums without a theoretical foundation. Unsurprisingly, IDW Practice Note 1/2014 therefore makes it clear that the objectified business valuation of small and medium-sized enterprises (SMEs), just like the valuation of large companies, must be based on a capital market theory model such as the Capital Asset Pricing Model (CAPM).
This requirement does not initially speak against the use of factor models to determine discount rates for business valuation. However, the widespread practice in valuation practice of applying lump-sum surcharges to the cost of capital rate when valuing small and medium-sized companies in order to price in a supposedly higher risk is thus negated by the FAUB practice note and assessed as inadmissible.
The size premium remains a controversial topic in business valuation. Although empirical studies show higher returns for smaller companies, there is no theoretical basis within the CAPM that justifies such a premium. The application of flat-rate premiums is rejected by IDW Practice Note 1/2014. Valuation professionals should therefore be cautious and rely on sound models and methods to determine the discount rates.
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