The Absence of a Size Effect Relevant to the Cost of Equity
Business Valuation Review, Forthcoming
Posted: 13 Jun 2017 Last revised: 22 Jan 2018
Date Written: September 8, 2017
In this paper, I evaluate whether there is a size effect that is relevant to the cost of equity. I first analyze what model investors use to determine the required rate of return on their investment and find investors prefer the CAPM over other models, even those that include a size proxy. I also show that over the period 1981 to 2016 small stocks underperformed large stocks, which is inconsistent with the existence of a size effect. Finally, I determined that size effect studies have not been able to surmount the criticisms that the size effect lacks a theoretical basis and that the results of size effect studies are susceptible to data mining criticisms. Given these results, practitioners may have to reconsider the standard practice of augmenting their cost of equity with a size premium.
Keywords: size effect, CAPM, cost of capital
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