Business Valuation Review Volume 37: Issue 3

Hello, Everyone,

The theme of this issue is the “size effect.” We have four articles related to dealing with the impact of company size: two on the cost of equity and two on volatility measurements. The first one, by Clifford Ang, questions the evidence that there is a size effect with respect to the cost of equity. The second one, by Roger Grabowski, takes a differing view. The third and fourth articles, one by James Herr and the other by Vincent Covrig and his coauthors, deal with volatility measurements and company size.

I hope you enjoy the issue.

In this paper, I evaluate whether there is a size effect that is relevant to the cost of equity. I first analyze what model investors use to determine the required rate of return on their investment and find investors prefer the Capital Asset Pricing Model (CAPM) over other models, even those that include a size proxy. I also show that over the period 1981 to 2016, small stocks underperformed large stocks, which is inconsistent with the existence of a size effect. Finally, I conclude that size effect studies have not been able to surmount the criticisms that the size effect lacks a theoretical basis and that the results of size effect studies are susceptible to data mining criticisms. Given these results, practitioners should reconsider the standard practice of augmenting their cost of equity with a size premium.

In this paper, I will review the size effect, potential reasons why one observes the size effect, and correct common misconceptions and address criticisms of the Size Premia (SP). Specifically, we demonstrate that the size premium critique by Cliff Ang²is not warranted and that the alternative methodology proposed by that author is misleading and cannot be considered as an alternative to the Duff & Phelps' SP. Subsequently, we will highlight some methodological issues with his proposed alternative. The methodology the author is proposing is picking up the statistical errors that he was set to avoid by proposing the same methodology. I will discuss other criticisms we have encountered. Finally, I will provide some practical guidance on applying SP.

Many valuation practitioners rely on equity volatilities when performing equity allocations, derivative valuations, discounts for lack of marketability, or contingent consideration analyses. Yet in contrast to other commonly accepted valuation adjustments,¹ practitioners still appear hesitant to adjust historical or implied volatilities from publicly traded comparables for differences in size when performing these types of analyses, despite theory that these factors should impact equity volatility.² Instead, preference is usually made in the industry to adjust equity volatilities for leverage alone.

In this paper I provide analytical support across a twenty-year time horizon using a five-year lookback period to examine the empirical impact of size and leverage on equity volatilities.

I find that size has substantial impact on equity volatilities and provide suggested volatility size adjustments for equity volatility. Further, I find evidence that while leverage does have an impact on equity volatilities, the impact is less than what the Merton model would imply. I find interesting evidence that equity volatilities may behave counter to the Merton model with or without adjusting for size.

Editor's Column

The Absence of a Size Effect Relevant to the Cost of Equity

The Size Effect Continues To Be Relevant When Estimating the Cost of Capital

The Impact of Size and Leverage on Equity Volatility

Size-adjusting Volatility

From the Chair

Volume 37, No. 3 — Complete Issue

From the Editor

Customer Concentration: Good, Bad, or Ugly?

From the Chair

Delaware Valuation Decisions, 2021 to 2024

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