Why We Should Not Add a Size Premium to the CAPM Cost of Equity

Abstract

Practitioners commonly augment the CAPM cost of equity by adding the Size Premium in Excess of CAPM published in the Ibbotson and Duff & Phelps yearbooks. However, the empirical evidence following Banz’s paper in 1981 does not support the existence of a size premium. Moreover, even if a size premium is deemed to be warranted, the Size Premium in Excess of CAPM as calculated by Ibbotson and Duff & Phelps are inconsistent with the CAPM cost of equity estimated by valuation practitioners and it also does not appropriately measure the size premium applicable in a DCF analysis. Therefore, adding the Size Premium in Excess of CAPM is no different than adding an arbitrary number to the CAPM cost of equity. In this paper, I provide an illustration of how to calculate a Practitioner-Consistent Size Premium to potentially resolve these issues. However, the results of that analysis yields unreliable results.

Keywords: CAPM, size premium