Business valuation size risk premia for small companies are rising
One of the key elements in business valuation of any size is risk assessment. Whether you use the direct capitalization methods, such as the Multiple of Discretionary Earnings technique, or the Discounted Cash Flow method, you need to calculate the capitalization and discount rates to capture that risk.
Business valuation and risk measurement
The Build-Up model is perhaps the most common way to calculate the discount rates. If you take a look at the build-up formula, you will notice that the company size risk premium is one key element. Generally, the smaller the company, the riskier it is and the higher the corresponding size risk premium number.
Small companies are riskier than larger competitors
So how do the company sizes affect their risk in this economy? The spread may be surprising to some. In fact, for small public companies with market capitalization below $50M the size risk premium exceeds 13.9%.
On the other hand, larger mid-market firms with market cap above $500M have a size risk premium falling below 2.84%.
Business value is affected by company size
This means that, for example, the equity discount rate for a $50M company in the construction industry can be around $26.7%. For a $500M counterpart, the discount rate is just 15.65%.
If both companies show minimal earnings growth in 2011, each $1,000,000 in net cash flow of the small company is worth about $3.75M compared to $6.39M for the larger firm, a 71% difference in business value!
Business risk rises quickly for smaller firms
What is interesting is that the size risk premium does not vary smoothly with company size. In fact, the relationship looks more like a hockey stick with a break point somewhere around $150M in market capitalization.
Size matters: Key business value enhancing factors for bigger firms
What makes the larger companies seem so much less risky in the eyes of business people today? Here is our short list:
- Market and product diversification of larger companies reduces their risk.
- Larger companies have succeeded in building very strong balance sheets to manage their financial risk better.
- Bigger businesses have a much easier time attracting capital – both debt and equity.
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7 Comments
Sharon says:
How does one determine the size premia for a privately-held company? I know that Ibbotson’s SBBI yearbook has size premia based on market cap but for a non-public company how is the size determined?
Harry says:
The Ibbotson SBBI Valuation Edition yearbook, now replaced by the Duff and Phelps Valuation Handbook, is indeed one key source of company size risk premia.
The data are used for building up discount rates for private companies. You will need to estimate the equity value of the private firm as a proxy for its market capitalization.
In addition, private company discount rates usually include an additional element known as the company specific risk premium (CSRP). Note that this so-called unsystematic risk is not observable in the public capital markets.
Iuri Colares says:
When valuing a small private company for acquisition by a new private owner, using the discounted cash flow (DCF) approach, in addition to company size risk premium and company specific risk premium (CSRP), should I also apply the discount for lack of marketability (DLOM) to the DCF business value? Damodaran argues that applying both company size risk premium and DLOM would double count for illiquidity.
Harry says:
Generally, DLOM discounts are used to account for the differences in marketability of public versus private companies. An example would be discounting the valuation multiples you get from a data set of public companies before applying the multiples to valuation of private firms. This shows clearly in the methodology of estimating DLOM – restricted stock and pre-IPO studies.
If you are valuing a company using the discounted cash flow method, you should focus on forecasting the business earnings and calculating its discount rate directly. Your analysis should account for any marketability restrictions.
As an aside, DLOM and company size risk premia are different concepts. Regardless of which side of the company size risk premium argument you take, the concept of marketability deals with the additional risk inherent in non-marketable business interests. Company size risk premium, if it exists, deals with the relative risk faced by smaller companies compared to their larger competitors. The jury on that last is still out.
Iuri Colares says:
Harry,
Thank you very much!
Best regards,
Iuri
Iuri Colares says:
Is company specific risk premium (CSRP) in Valuadder model equivalent to illiquidity premium?
Harry says:
No. CSRP is a form of unsystematic risk arising out of lack of diversification typical of small business investment. This is not to be confused with the lack of marketability discount which applies to valuation of relatively illiquid ownership interests such as restricted or letter stock.