Size Premium
Definition
An additional return demanded by investors for holding the equity of smaller companies, reflecting the empirically observed tendency for small-capitalisation stocks to earn higher returns than predicted by the Capital Asset Pricing Model alone. Size premiums are commonly sourced from the Duff & Phelps (now Kroll) Cost of Capital Navigator and are added to the cost of equity in the build-up method or as a modification to CAPM. The existence and magnitude of the size premium remain subjects of academic debate.
Complementary Terms
Concepts that frequently appear alongside Size Premium in practice.
The incremental return that investors require for holding equities over risk-free government bonds, reflecting the additional risk associated with equity ownership. The ERP is a critical input to cost of equity estimation under both CAPM and build-up methods.
An adjustment applied to the standard WACC to reflect the additional risk associated with specific intangible assets or early-stage businesses. Intangible-heavy investments typically warrant a higher discount rate than the firm-level WACC because their cash flows are less certain and more sensitive to competitive and technological disruption.
An additional return added to the cost of equity to reflect idiosyncratic risks unique to the subject company that are not captured by beta, the equity risk premium, or the size premium. Common factors justifying a specific company risk premium include customer concentration, key person dependence, regulatory exposure, limited product diversification, geographic concentration, and early-stage business risk.
The additional amount a buyer pays above the pro-rata market value of a company's shares to acquire a controlling interest. The control premium reflects the value of being able to direct the company's strategy, operations, capital allocation, and management.
The additional value attributed to a business or asset that can grow revenue significantly without a proportional increase in cost. Scalability premiums are characteristic of intangible-heavy businesses — particularly those built on software, data, and network effects — where marginal costs approach zero at scale.
A technique for estimating the weighted average cost of capital by constructing the cost of equity from individual risk components rather than deriving it solely from market data. The build-up method typically starts with the risk-free rate and adds an equity risk premium, size premium, industry risk premium, and company-specific risk premium.
The theoretical rate of return on an investment with zero default risk, used as the foundation for building discount rates in valuation. In practice, the yield on government bonds of a maturity matching the expected cash flow duration serves as a proxy — typically US Treasury bonds for USD-denominated valuations or UK gilts for GBP-denominated analyses.
A measure of a company's financial performance that calculates the value created above the required return of investors, defined as net operating profit after tax minus the cost of capital employed. EVA highlights whether a firm's intangible and tangible assets are generating returns that exceed their cost of capital.
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