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Often business valuers use a higher required equity return for a small business compared to a similar, but larger business.

The difference in equity returns is the small-cap premium. It refers to the premium small capitalised businesses (a low market value) are expected to earn compared to large capitalised businesses (high market value).

The higher the small-cap premium, the higher the demanded equity return and the lower the business value.

Basis for the premium

The basis for the premium is that in the listed equity markets, small sized firms, by market capitalisation, are often observed to generate higher returns than large capitalised firm.

According to Banz (1981) the bottom 20% of NYSE firms, by market capitalisation, produced a 6% return above the largest NYSE firms, between 1936 and 1977.

There is plenty of research to show that similar premiums exist in other international markets. There is also plenty of research to show no premiums exist!

Premiums are also observed to change between industries.

Small-cap premium volatility

One of the critical problems with measuring a small-cap premium is that historically observed premiums are volatile. The observations have a high standard of error.

According to Professor Damodaran, the average US equity small stock premiums between 1926 and 2015 were 3.82%. All very good. (Aswath Damodaran, Equity Risk Premiums: Determinants, estimations and implications, March 2016).

Unfortunately, the observed premiums have a standard of error of 1.91%. This means if you want to be 95% confident in your estimate of your small-cap premium, you need to use a range of between zero and 7.64%.

Why use a small cap premium?

There needs to be logic in applying the small-cap premium. For example, small-cap companies may be more exposed to market risk than larger cap companies. But smallness in itself isn’t a risk.

The business valuer must provide a supportable explanation of why the small company is riskier than the larger company and quantify that risk. Maybe the smaller firm is less diversified, say in customers and suppliers, and so more prone to failure.

Is liquidity reflected in the small-cap premium?

Some of or all the observed small cap premium could be due to illiquidity. Smaller stocks often have fewer buyers and sellers than larger stocks. The stock is thinly traded.

The consequence of selling a thinly traded stock is that an investor may have to accept a discount on the price to move the stock quickly. In larger stocks, investors can find plenty of willing buyers.

Therefore, the business valuer, when using a small cap premium, needs to ensure liquidity isn’t double counted, ie. applying a small cap premium and a liquidity discount.

Simon specialises in valuing private businesses for parties involved in disputes, business buyers or sellers seeking to transact and business owners raising finance or restructuring.


Simon specialises in valuing private businesses and quantifying damages. He is a Chartered Accountant Business Valuation Specialist and Forensic Accounting Specialist with Chartered Accountants Australia and New Zealand (CA ANZ). He chairs the CA ANZ Business Valuation group for Queensland and is a member of the CA ANZ Trans-Tasman Business Valuation Committee.

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