Debt beta is the result of the ratio of credit spread and market risk premium. If it is taken into account, the company value usually increases.
What is a “size premium”?
In valuation practice, it is sometimes common to postulate an increased risk for small and medium-sized companies and to take this into account via an additional risk premium, a so-called “size premium”. The empirical foundation of the “Size-Premium” dates back, among other things, to the work of French & Fama at the beginning of the nineties. This article explains the background of “Size-Premium” and discusses its significance for the practice of company valuation.
The “size effect” describes the empirical observation that listed companies with a comparatively low market capitalization, so-called small caps, generate a higher return than companies with a comparatively high market capitalization. These effects were identified for the first time by Banz (1981) for the American stock market. Chan & Chen (1991) and Fama & French (1993) also come to this conclusion. Subsequent work by Zhang (1995) and van Dijk (2011) also confirmed yield premiums for smaller listed companies. The previously mentioned works differ fundamentally in terms of their attempts to explain the “size effect”. What this work has in common, however, is that there are comparatively higher structural risks for smaller listed companies, which leads to higher return expectations on the part of investors in the form of an additional risk premium.
Is the CAPM compatible with a “Size Premium”?
The empirical proof of the size premium sparked a controversial scientific discussion. The subject of discussion was and is regularly that at least the CAPM does not provide for a size-dependent risk surcharge as a market equilibrium model to explain the expected returns and this does not seem to be integrated into the CAPM model world. Systematic risk is relevant to valuation within the meaning of CAPM and is therefore the only company-specific factor influencing the amount of a company's expected return.
In CAPM, this systematic risk is model-endogenously derived as a result of the behavior of all market participants, but is not explicitly stated in terms of content. In their investigation, Fama/French only use a purely empirically-based 3-factor model in the sense of Arbitrage Pricing Theory (Ross 1962) with specified factors. The nature of Fama/French's approach is fundamentally different from the establishment of a theoretically based market equilibrium model to explain the return expectations of rational investors on an efficient capital market.
IDW Practice Note 1/2014: No flat-rate, size-dependent surcharges
The application of purely empirically based models, including the previously mentioned Fama/French model, ultimately opens the door to a high degree of arbitrariness in the use and definition of surcharges without theoretical basis. Not surprisingly, IDW Practice Note 1/2014 therefore clarifies that the objectified company valuation of small and medium-sized companies (SMEs) as well as the valuation of large companies must be based on a capital market theory model such as the Capital Asset Pricing Model (CAPM).
First of all, this requirement does not fundamentally oppose the use of factor models to determine discount interest rates for company valuation. However, the widespread practice practice of applying lump sum surcharges to the cost of capital rate when valuing small and medium-sized companies in order to price in a supposedly higher risk is denied and rated as inadmissible by the FAUB Practice Note.