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The size effect in business valuation – The causes and risks of higher-than-average returns from small companies

In the context of business valuation, it is always noticeable that, when compared with large companies, small companies generate higher-than-average returns. This so-called size effect appears to create the possibility of generating superior returns on the market through targeted investments in small cap shares. In this report, we analyse the causes of the size effect more closely, although there is a particular focus on the risks of this supposedly promising investment opportunity. As a last point, we present an approach for taking the size effect into consideration in business valuation.

Capital market observations on the size effect

One of the first and most extensive studies on the size effect was by two academics, Fama and French, in 1992. The capital market observations made within the scope of this study clearly showed that the return on a share - understood to be the total return – almost continuously decreases as the market cap increases. This size effect was likewise observed by other researchers and in a wide range of capital markets. However, the capital market studies also showed that, over the course of time, the size effect is not stable and sometimes goes through phases when it weakens considerably.

Then again, a look at the recent German capital market returns, in the third quarter of 2022, shows a significantly positive size effect. When the returns from the 40 largest German companies in the DAX index are compared with the 70 small cap companies in the SDAX it is noticeable that the small cap shares in the SDAX exhibited higher returns, on average, than the shares of the DAX companies (as at: 3.8. 2022).

Small companies with low market capitalisation thus appear to generate considerably better returns in the long term. In order to ascertain more precisely what is behind this size effect, in the following sections, we examine the underlying risks and other causes as well as explanatory hypotheses.

Risk analysis

The most frequently cited explanation for the size effect is, arguably, the assumption that small and large companies are differentiated on the basis of their risks and, for this reason, different returns can be expected. This effect is amplified by the fact that, for valuation purposes, the Capital Asset Pricing Model (CAPM) is generally used. However, given that within the scope of this valuation model it is only systematic market risks that are taken into account and not company-specific or non-systematic risks, such as company size; even on a risk-adjusted basis there are discrepancies between the returns for small and large companies.

In addition, small and large companies exhibit major differences in their liquidity or the tradability of their securities. The shares of small companies are generally considered to be illiquid and are, therefore, subject to a higher liquidity risk. This increased risk is associated with a correspondingly higher required rate of return that, in turn, impacts the return that is actually observed on the market.

Furthermore, when comparing small and large companies, it is noticeable that small companies are affected by insolvency risks to a greater extent. Frequently, in terms of capitalisation, small companies are in a less favourable position and therefore have a higher default risk. This increased risk of small companies likewise justifies an additional risk premium that has quite obviously not been addressed by the CAPM. As a consequence, positive excess return effects ultimately develop that explain the size effect.

Investor behaviour

Besides the observed risk factors, aspects from the area of behavioural finance can also be used to account for the size effect. Such tentative explanations are generally based on the irrational behaviour of capital market operators. A well-known phenomenon in financial market theory is the so-called overreaction hypothesis. The argument here is that small companies are generally ones that, in the past, often demonstrated poor performance. If investors now overrate the past performance then the share price of small companies will be too low and, by implication, will result in higher returns once the overreaction has ultimately been corrected.

Another behaviour-oriented tentative explanation relates to investor sentiment. Various studies have found that, in this respect, investor sentiment and the size effect are negatively correlated. That means that the size effect is at its weakest when investor sentiment is positive. The reason for this is that, during times of optimistic sentiment, investors tend to overvalue the securities of more risky companies - such as, e.g., small companies. However, when viewed over a longer time period, this results in lower returns since the mispricing of the share will be corrected and it will revert to its fundamental value.

Other explanatory hypotheses

Besides the above-mentioned risk and behaviour-based explanations, there is a range of other explanatory hypotheses for the size effect. This is, among other things, also frequently linked to the prevailing phase of the economic cycle. This means that the size effect will be amplified during expansion phases while during recessionary market phases it will weaken or be negative. This was the case, for example, during the 2007- 2008 financial crisis. During this economic phase, there was a decline in the development of returns for small cap shares and this was considerably below the return for large cap shares.

Furthermore, it is well-known that the shares of small companies are generally given less attention by analysts and the media. In this respect, researchers have found that the shares of neglected companies generally achieve higher returns than large companies that are covered and scrutinised by equity analysts on a regular basis. This phenomenon is also known as the so-called neglected firm effect. 

Outlook: In order to take proper account of the size effect within the scope of business valuation, several academic researchers have developed alternative calculation models to the CAPM that price in company-specific factors, such as size, in addition to the systematic risk (beta factor). An example worth mentioning here is the Fama-French Three-Factor Model In view of the complexity of this and other multi-factor models, in the USA, the so-called Modified CAPM (MCAPM) has become established for business valuations - it takes the size effect into account with an additional size premium.

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