Term · Valuation
Size Premium
In briefThe size premium is the additional required return, or excess return, of smaller companies over larger ones observed in studies. In valuation it is sometimes applied as an add-on to the cost of equity of small stocks, though its existence and magnitude are disputed.
Definition
The size premium refers to the additional required return, or return, of smaller companies over large ones observed in empirical studies. In valuation it is sometimes applied as an add-on to the cost of equity of small stocks. Whether it exists, and at what level, is academically contested and time-dependent.
How it is calculated
Formula. Adjusted cost of equity = Base cost of equity + Size premium (add-on in %)
Why it matters for small caps
Anyone valuing small and micro caps frequently encounters a size add-on in the discount rate, which noticeably lowers the enterprise value. An add-on chosen too high or arbitrarily can distort valuations and should be questioned critically.
Common misreadings
- The size premium is understood as a guaranteed, constant additional return of small stocks, even though the empirical evidence is inconsistent and highly dependent on the time period and definition.
In the process
Frequently asked
How does a size premium affect the valuation?
As an add-on to the cost of equity, it raises the discount rate and thereby lowers the calculated enterprise value.
Is the size premium uncontested?
No. The empirical evidence is inconsistent and highly dependent on the period, region and definition of the size classes.
Where does the size premium appear?
Above all in DCF valuations of small companies, where it affects the cost of equity and thus the WACC.
Related terms
Education only, not investment advice. Ranges and thresholds are didactic orientation values, not an official standard.