VPS StraightTalk Webinar, October 20, 2022 This summer and fall 2022, within the business valuation profession, one of the most contentious issues has been “which cost of capital should business valuation professionals use when valuing a small business?” First, Dr. Damodaran advocated the implied equity risk premium with the capital asset pricing model without adding a size premium or company specific risk. He adjusts for other risk factors (size and company specific risks) by adjusting the forecasted cash flows. Next, James Hitchner, CPA, ABV, CFF, responded to Dr. Damodaran’s criticism. Shortly thereafter, Eric Nath, founder of Eri Nath & Associates,…
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Considerations in Applying a Size Premium (Part III of III) In this third and final article, as displayed in Exhibits 1 through 4 in Part 1 of this three-part article, the size effect has been observed even when looking at recent periods starting in 1981 and 1990. If one holds that you should not apply the SP in the MCAPM and that beta should be the only measure of risk, one is supporting using the pure or textbook CAPM to estimate expected returns. But that cannot be correct as the literature clearly demonstrates. Though the pure CAPM is a good…
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Measuring the Relative Performance of Small Stock vs. Large Stock and the Cost of Equity Roger Ibbotson and James Harrington discuss two different ways of measuring the relative performance of small stocks versus large stocks in this article: (i) the “small stock premium” and (ii) the “beta-adjusted size premium”. Ibbotson and Harrington demonstrate why using a non-beta-adjusted size premium within the context of the capital asset pricing model (CAPM) to estimate cost of equity capital will likely “double count” beta risk, and therefore overstate risk and understate value. The authors also demonstrate that a non-beta-adjusted size premium used in conjunction…