Not investment advice. Educational reading. See Disclaimer.
L.10 · ADVANCED · 4 MIN
Size Premium and the Fama-French Alternative
CAPM says one number prices an equity: expected return equals risk-free rate plus beta times the equity risk premium. Empirically, that prediction breaks down on small-cap stocks — they have consistently earned returns above what CAPM predicts. The 'size premium' is the additional cost-of-equity adjustment practitioners add to small-cap valuations to account for this gap. But the size-premium literature has shifted substantially since the early 2000s, and the disciplined practitioner needs to understand which sample window supports which size-premium magnitude, how Fama-French three-factor reframes the problem, and what the build-up method is actually claiming.
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
§ 02
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.
§ 03
Cost of Equity = Risk-Free + Beta * ERP + Size Premium + Specific Risk Premium
§ 04
Pick a small-cap stock under $1B market cap in **Fundamentals**. Pull its observed equity beta and compute three cost-of-equity estimates: (1) strict CAPM with no size adjustment, (2) build-up method with a 200 bp size premium and a 100 bp specific-risk premium, (3) if available, the Fama-French three-factor estimate using the firm's SMB loading (small-cap funds and academic Ken French data series often publish these). How wide is the spread? A 200-300 bp spread is normal; a 500+ bp spread is a flag that the firm has unusual factor exposures and the methods are NOT bracket-matching.
§ 05
A private-equity firm evaluating a $250M-revenue regional services business proposes a cost of equity of 18%, decomposed as 4% Rf + 1.30 * 5% ERP + 3.50% size premium + 4% specific-risk premium (key-person, customer concentration, key-supplier). An academic challenges: 'the size premium is unsupported on post-2000 US data — your 18% number includes an obsolete academic input'. What is the most defensible analyst response?
§ 06
Fama-French three-factor is structurally a SUBSTITUTE for the build-up method's size premium, not a complement. Both are trying to capture the same empirical phenomenon (small-cap excess returns) via different formal machinery. If a model uses Fama-French SMB loading to price the equity, adding a separate 'size premium' on top is double-counting. The disciplined analyst picks ONE method — strict CAPM (size effect priced via beta-only, fine for large-caps where the size effect is muted), build-up (size premium added explicitly, defensible for small-cap and micro-cap), or Fama-French three-factor (size and value priced via factor loadings, most rigorous when factor data is available) — and stays in that framework throughout the model. Mixing methods is the most common source of cost-of-equity estimates that look defensible but compound multiple corrections for the same underlying empirical fact.
§ 07
Two analysts produce cost-of-equity estimates for the same $400M private services target. Analyst A uses strict CAPM and reaches 10.5%. Analyst B uses the build-up method with a 200 bp size premium and a 100 bp specific-risk premium and reaches 13.5%. The DCF using Analyst A's WACC produces a fair-value range of $480M to $560M; the DCF using Analyst B's WACC produces a fair-value range of $360M to $420M. The deal is offered at $440M. How should the investment committee read the divergence?
Five questions · AI feedback
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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?
