Hi everybody,
Had this question during an interview (M&A internship)... did not answer excatly.
When calculating the cost of equity (CAPM) for a small cap, how do you determine the size premium you add?
Many thanks fow you answers !!
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Empirically it has been that the smaller the size the bigger the risk. So following that, you take your beta and add anywhere from 1.5% to 10% depending on how small the company is. Since it is a small cap, I would assume somewhere between 1.5 % - 3% My guess would be to look at comps and see the premiums of similar companies.
Okay, I see. It is roughly what I said - market decides the size...but I thought we could calculate an exact one
Thx !!
lmao it's the number your MD tells you to play with when you're not at the right WACC
Don't know if this is exactly right, but size premiums have to do with risk. Small companies will typically look to undergo dramatic growth overtime. This is risky because it is impossible to know what to pay for that growth given that you cannot know whether it will actually be achieved. Normally, earnings can be capitalized and then discounted based on current market conditions to give you a value to pay for those earnings. With the risks inherit in earnings not yet achieved, it is normal to tack on an additional discount factor to the discount rate. This additional factor can be the growth rate.
For example, if you would normally pay for earnings at a discount rate of 7% for comparable companies and your target is expected to grow at 4% over the horizon, your target's respective discount rate will be 11% ( Comp disc rate + target g rate). It's the same thing that's true if expected growth is 10% or more. Think about it as if you're paying for the risk of historical earnings (reasonably expected earnings based on historical performance) or in the case of small high growth companies, risk not yet achieved but expected in the future (earnings that should be looked at with a highly skeptical perspective because of an unknown future).
So basically size of the premium is the growth rate?
Take what I say with a grain of salt because I think just as the above poster said there could be more particulars that will come into play. But one way to look at it is definitely this risk surrounding around paying for expected earnings growth, which is not yet achieved.
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