Size Premium: WACC and Business Valuation

Introduction: Foundations and Stakes of Integrating Size Risk into the WACC

In the context of discounted cash flow (DCF) approaches, the financial valuation of a company relies on a structural variable: the Weighted Average Cost of Capital (WACC). This rate serves as the mechanism for converting future flows into present value and directly influences the resulting valuation level. A marginal variation in the cost of equity can produce a significant effect on the enterprise value, particularly when the flows present a long duration or sustained anticipated growth.

In its standard academic formulation, the cost of equity is determined using the Capital Asset Pricing Model (CAPM), which expresses the return required by investors as a function of the risk-free rate and the market premium adjusted by the beta. However, this model is based on the hypothesis of an efficient and diversified market, in which only systematic risk is compensated. This theoretical construction raises a difficulty when transposed to small and medium-sized enterprises (SMEs), particularly private ones, whose structural characteristics differ significantly from the large capitalizations observed on organized markets.

It is in this context that the notion of the size premium intervenes. It designates the additional return historically observed or required to compensate for the additional risk associated with small-capitalization companies. The empirical existence of a size effect was documented by Rolf W. Banz (1981), who highlighted an inverse relationship between market capitalization and the average return on stocks. This anomaly was later integrated into the multi-factor model developed by Eugene F. Fama and Kenneth R. French (1992), through the SMB (Small Minus Big) factor, confirming that size constitutes an additional explanatory factor for returns.

Consequently, several questions arise. Should the size premium be systematically integrated into the WACC in the context of an SME valuation? Are data from listed markets adapted to private companies? Is there a risk of double counting with the specific premium? And above all, according to what rigorous method should one proceed in order to maintain the economic consistency of the discount rate?

Academic and Empirical Origin of the Size Premium

The size premium finds its origin in empirical work conducted on the US financial markets at the turn of the 1980s. This prediction was challenged by the founding study by Rolf W. Banz published in 1981 in the Journal of Financial Economics. Banz highlighted a statistically significant relationship between the size of listed companies and their risk-adjusted returns. This anomaly was further developed and formalized by Eugene F. Fama and Kenneth R. French in their 1992 article published in the Journal of Finance, introducing the SMB (Small Minus Big) factor.

This methodology was adopted and enriched by professional databases developed by Duff & Phelps, today integrated within Kroll. A study published in The Journal of Entrepreneurial Finance in 2025 (Galbraith) shows that the relationship between size and premium follows a strongly non-linear logarithmic dynamic, with a rapid increase in the required additional return at the lowest levels of capitalization (pp. 33–41).

Economic Definition and Conceptual Scope of the Size Premium

The size premium can be defined as the additional return required by investors to compensate for the additional risk associated with low-capitalization companies. On an economic level, several mechanisms explain this increased return requirement: (1) limited operational diversification, (2) reduced liquidity of the security or investment, (3) limited bargaining power with economic partners, (4) more pronounced information asymmetry. It is important to distinguish the size premium from the company specific risk premium (which reflects idiosyncratic risks) and from the illiquidity discount (which adjusts value rather than the discount rate).

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Conditions for Integrating the Size Premium into the WACC

The integration of the size premium into the WACC cannot be automatic. The size premium finds its full relevance when: (1) the evaluated company presents an economic capitalization significantly lower than the thresholds observed in listed markets, including in the lowest deciles published by Kroll; (2) the company presents high structural concentration; (3) access to capital markets is restricted. Conversely, when the company belongs to a diversified group or when a substantial specific premium is already integrated, an additional adjustment for size could lead to redundancy.

Economic Foundations Justifying the Integration of the Size Premium

The integration of the size premium does not constitute a simple statistical adjustment. It relies on identifiable economic foundations: (1) increased economic vulnerability of small structures; (2) limited market power and economies of scale; (3) reduced liquidity and transferability of the investment; (4) more pronounced information asymmetry; (5) limited financial flexibility. The integration of this premium must be carried out with discernment to avoid overvaluation of risk.

Modalities of Integration of the Size Premium into the WACC

The size premium intervenes exclusively at the level of the cost of equity, and not at the level of the cost of debt. In a build-up approach, the cost of equity is expressed as: Ke = Rf + β × (Rm − Rf) + Size Premium + Specific Premium. The size premium thus inserts itself as an autonomous component of the cost of equity. It modifies neither the risk-free rate nor the market premium but constitutes an additional adjustment intended to reflect the capitalization segment of the company.

Determination and Calculation of the Size Premium

Empirical Approach Based on Historical Returns

In its simplest form, the empirical size premium is expressed as: Size Premium = Rsmall − Rmarket, where Rsmall is the historical average return of small caps and Rmarket is the historical average return of the global market. This approach presents strong academic robustness but its direct application remains essentially relevant for listed markets.

Practical Approach by Capitalization Deciles

In professional practice, the size premium is most often determined from premium tables by capitalization segments, as popularized by Roger G. Ibbotson via the SBBI Yearbooks and later institutionalized through Duff & Phelps (now Kroll). The method proceeds in three steps: estimate the equity value, identify the closest capitalization category, and apply the corresponding size premium.

Logarithmic Econometric Approach

To overcome the granularity limits of decile tables, an econometric approach models the premium as a continuous function of size: Size Premium = a + b × ln(Equity Value). The empirical results of Galbraith (2025) show that the relationship between size and premium is non-linear and is more adequately expressed via a logarithmic function. The estimated equation: Size Premium ≈ 0.2500 − 0.0245 × ln(Equity Value in USD millions). This approach produces a continuous premium with no threshold effect between deciles.

Full Calculation Example

Swiss company with equity value CHF 8 million. ln(8) ≈ 2.079. Size Premium ≈ 0.2500 − 0.0245 × 2.079 ≈ 4.9%. With Rf = 1.25%, Swiss market premium = 5.50%, beta = 1.10: Ke = 1.25% + 1.10 × 5.50% + 4.9% = 12.20%. Without size premium: Ke ≈ 7.3%. With capital structure 65% equity / 35% debt, Kd = 3.5%, T = 15%: WACC ≈ 9.0% (vs ≈ 6.0% without size premium). The integration of the size premium thus significantly raises the WACC and mechanically reduces enterprise value obtained by DCF.

Indicative Size Premiums for Private SMEs: Application of an International Transactional Model (2025)

CEO Statement

The size premium must never be applied mechanically. It constitutes neither a universal constant nor a standardized percentage. It is the expression of a real economic risk: reduced liquidity, managerial dependence, limited access to financing, commercial concentration, non-institutionalized governance. Whenever possible, the evaluator should calculate the size premium themselves, using adapted econometric modeling or consistent logarithmic calibration. The determination of the size premium thus constitutes an exercise in balance between academic rigor, compliance with professional practices, and concrete economic analysis of the case. The WACC must never be the result of an automatic process, but that of a structured, documented, and defensible reasoning.

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Conclusion: A Structural Variable of the Cost of Capital

The size premium constitutes neither a marginal anomaly nor a simple accessory adjustment to the cost of equity. It is at the very heart of the determination of the return required by the investor and, by extension, of the construction of the WACC. Its determination requires: an identifiable methodological base; consistency with the chosen model; a documented economic justification; a sensitivity analysis on the final valuation. In terms of valuation, rigor does not consist of applying a standard percentage, but of demonstrating that the chosen rate faithfully reflects the economic reality of the analyzed company.

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Author

Aristide Ruot, Ph.D. — Founder & Managing Director