Size-premium findings across five research windows
| Empirical Window | Size-Premium Finding | What This Tells the Practitioner |
|---|---|---|
| 1936-1975 US (Banz 1981) | 5-7% annual excess return for smallest-decile vs largest-decile | The original finding; the 1980s build-up method was calibrated to this sample |
| 1963-1990 US (Fama-French 1992) | Confirmed Banz; reframed as the SMB factor in three-factor model | Recast size as a systematic-risk premium rather than a CAPM anomaly |
| 1980-2010 US (Asness et al, AQR) | Size effect substantially weakened on large-caps; persistent on micro-caps when interacted with quality | Size is NOT a free lunch on every small-cap; only on small-AND-quality firms |
| International (Fama-French 2017) | Mixed; size effect varies by country and sample window | US-calibrated size premia do not transfer cleanly to international markets |
| Duff and Phelps / Kroll Size Premia Reports | 200-400 bps for sub-$500M firms, decile-stratified | Practitioner-standardized reference; defensible but tied to specific underlying sample windows |
Where academics and practitioners split on size
The size premium is one of the few cost-of-capital inputs where 'what does the academic literature say' and 'what do practitioners do' have diverged materially over the last 20 years. Academic consensus has weakened on the universality of the size effect; practitioner conventions (Kroll, Duff and Phelps, vendor-default WACC tools) still apply 200-400 bps for sub-$500M firms because the convention has not been retired and the alternative (CAPM with no size adjustment) demonstrably understates cost of equity for small-cap private targets where PE firms are routinely transacting at 15-20% discount rates. The disciplined practitioner uses the size premium as a defensible convention rather than a theoretical absolute, names the contested status, and brackets the cost-of-equity estimate with a 100-200 bp band rather than presenting it as a point.
The build-up cost-of-equity formula
Cost of Equity = Risk-Free + Beta * ERP + Size Premium + Specific Risk Premium
Compare three cost-of-equity estimates for a small-cap
Worked example: what the size premium does to a valuation
The same company at two discount rates. A small-cap generates $10 million of free cash flow to equity, growing 2% in perpetuity. Plain CAPM: 4% risk-free + 1.2 beta x 5% equity risk premium = 10% cost of equity, so equity value = $10M / (0.10 - 0.02) = $125 million. Add a 3% size premium and the cost of equity is 13%: value = $10M / (0.13 - 0.02) = $90.9 million. One contested input removed more than a quarter of the valuation. That leverage is why the size premium is fought over so hard in fairness opinions, appraisals, and tax valuations -- the academic debate about post-1981 sample windows translates directly into eight-figure swings on mid-market deals.
One company, three cost-of-equity conventions
| Approach | Cost of equity | Implied equity value ($10M FCFE, 2% growth) |
|---|---|---|
| Plain CAPM (4% + 1.2 x 5%) | 10.0% | $125.0M |
| Fama-French three-factor (SMB loading priced in) | 11.4% | $106.4M |
| Build-up: CAPM + 3% size premium | 13.0% | $90.9M |
Defending a size premium against the academic critique
Fama-French size factor versus the build-up premium
Reading a CAPM-versus-build-up valuation gap
Sit with the ideas.
You are valuing a $350M market-cap regional industrial distributor. CAPM with a 1.15 beta gives a 9.75% cost of equity (4% risk-free + 1.15 * 5% ERP). A practitioner build-up adds 250 bps of size premium and arrives at 12.25%. A Fama-French three-factor estimate using the firm's SMB loading of 0.65 and HML loading of 0.30 produces 11.40%. The CFO challenges the analysis: 'the size premium has been disappearing in academic studies since the early 2000s — why are we adding it?' What is the most disciplined defense of the build-up choice over strict CAPM, and how do you frame the disagreement with the Fama-French estimate?