- If illiquidity is your bogey man in valuation, why use market capitalization as a stand-in for it? Market capitalization and illiquidity don’t always go hand in hand, since there are small, liquid companies and large, illiquid ones in the market. Four decades ago, your excuse would have been that the data on illiquidity was either inaccessible or unavailable and that market capitalization was the best proxy you could find for illiquidity. That is no longer the case and there are studies that categorize companies based on measures of illiquidity (bid ask spread, trading volume) and find an “liquidity premium” for illiquid companies.
- If illiquidity is what you are adjusting for in the small cap premium, why is it a constant across companies, buyers and time? Even if your defense is that the small cap premium is an imperfect (but reasonable) measure of the illiquidity premium, it is unreasonable to expect it to be the same for every company. Thus, even if you are valuing just privately owned businesses (where illiquidity is a clear and present danger), that illiquidity should be greater in some businesses than in others and the illiquidity (or small cap) premium should be larger for the former than the latter. Furthermore, the premium you add to the discount rate should be higher in some periods (during market crises and liquidity crunches) than others and for some buyers (cash poor, impatient) than others (patient, cash rich).
- Even if you can argue that illiquidity is your rationale for the small cap premium and that it is the same across companies, why is it not changing over the time horizon of your valuation (and especially in your terminal value)? In any valuation, you assume through your company’s cash flows and growth rates will change over time and it is inconsistent (with your own narrative for the company) to lock in an illiquidity premium into your discount rate that does not change as your company does. Thus, if you are using a 30% expected growth rate on your company, your “small” company is getting bigger (at least according to your estimates) and presumably more liquid over time. Should your illiquidity premium therefore not follow your own reasoning and decrease over time?
- If your argument is that size is a good proxy for illiquidity, that all small companies are equally illiquid and that that illiquidity does not change as you make them bigger, why are you reducing your end value by an illiquidity discount? This question is directed at private company appraisers who routinely use small cap premiums to increase discount rates and also reduce the end (DCF) value by 25% or more, because of illiquidity. You can show me data to back up your discount (I have seen restricted stock and IPO studies) but none of them can justify the double counting of illiquidity in valuation.
- Intuition: Analysts and investors not only start of with the presumption that the discount rates for small companies should be higher than large companies, but also have a “number’ in mind. When risk and return models deliver a much lower number, the urge to add to it to make it “more reasonable” is almost unstoppable. Consequently, an analyst who arrives at an 8% cost of equity for a small company feels much more comfortable after adding a 5% small cap premium. It is entirely possible that you are an idiot savant with the uncanny capacity to assess the right discount rate for companies, but if that is the case, why go through this charade of using risk and return models and adding premiums to get to your “intuited” discount rate? For most of us, gut feeling and instinct are not good guides to estimating discount rates and here is why. Not all risk is meant for the discount rate, with some risk (like management skills) being diversifiable (and thus lessened in portfolios) and other risks (like risk of failure or regulatory approval) better reflected in probabilities an expected cash flow. A discount rate cannot and is not meant to be a receptacle for all your hopes and fears, a number that you can tweak until your get to your comfort zone.
- Inertia (institutional and individual): The strongest force in corporate finance practice is inertia, where much of what companies, investors and analysts do reflects past practice. The same is true in the use of the small cap premium, where a generation of analysts has been brought up to believe (by valuation handbooks and teaching) that it is the right adjustment to make and now do it by rote. That inertia is reinforced in the legal arena (where many valuations end up, either as part of business or tax disputes) by the legal system’s respect for precedence and general practice. You may view this as harsh, but I believe that you will have an easier time defending the use of a bad, widely used practice of long standing in court than you would arguing for an innovative better practice.
- Bias: My experiences with many analysts who use small cap premiums suggest to me that one motive is to get a “lower” value”. Why would they want a lower value? First, in accounting and tax valuation, the client that you are doing the valuation for might be made better off with a lower value than a higher one. Consequently, you will do everything you can to pump up the discount rate with the small cap premium being only one of the many premiums that you use to “build up” your cost of capital. Second, there seems to be a (misplaced) belief that it is better to arrive at too low a value than one that is too high. If you buy into this “conservative” valuation approach, you will view adding a small cap premium as costless, since even it does not exist, all you have done is arrived at “too low” a value. At the risk of bringing up the memories of statistics classes past, there is always a cost. While “over estimating” discount rates reduces type 1 errors (that you will buy an over valued stock), it comes at the expense of type 2 errors (that you will hold off on buying an under valued stock).
- What is your justification for using a small cap premium? If the defense is pointing to history (or a data table in a service), it is paper thin, since that historical premium defense seems to have more holes in it than Swiss cheese. If it is intuitive, i.e., that small companies are riskier and markets must see them as such, I don’t see the basis for the intuition, since the implied costs of equity for small companies are no higher than those of large companies. If the argument is that everyone does it, I am sorry but just because something is established practice does not make it right.
- What are the additional risks that you see in small companies that you don’t see in large ones? I am sure that you can come up with a laundry list that is a mile long, but most of the risks on the list either don’t belong in the discount rate (either because they are diversifiable or because they are discrete risks) or can be captured through probability estimates. If it is illiquidity that you are concerned about, see the section on illiquidity above for my response.