Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 14

Size Effect¹

James Harrington

Introduction

Size as a Predictor of Equity Returns

The CRSP Databases

Possible Explanations for the Greater Returns of Smaller Companies

The Size Effect over Longer Time Periods

The Size Effect Tends to Stabilize over Time

The Size Effect: Empirical Evidence from Morningstar and Duff & Phelps Studies

Morningstar Studies

How Morningstar Size Premia Are Calculated

Morningstar Size Premia Are “Beta Adjusted”

Duff & Phelps Studies

Additional Measures of Size

How Duff & Phelps Size Premia Are Calculated

Duff & Phelps Size Premia Are “Beta Adjusted”

Duff & Phelps “Risk Premia over the Risk-free Rate”

Estimating Size Premia for a Nonpublic Company

Summary

INTRODUCTION

In Chapter 9 on the build-up method and Chapter 10 on the capital asset pricing model (CAPM), we made reference to the “size effect.” The size effect is based on the empirical observation that companies of smaller size are associated with greater risk and, therefore, have a greater cost of capital. While the size effect is a factor in other cost of capital models—for example, the Fama-French three-factor model (see Chapter 18)—in this chapter we discuss evidence of the size effect and its measurement in the context of the build-up method and the CAPM.

In this chapter we focus on the empirical evidence of the size effect provided by two independent sets of studies: the Morningstar studies and the Duff & Phelps studies.^2,3

Both the Morningstar and Duff and Phelps studies examine the ...