Size Premium Research Articles

Small and Vulnerable

We provide broad-based evidence of a firm size premium of total factor productivity (TFP) growth in Europe after the Global Financial Crisis. The TFP growth of smaller firms was more adversely affected and diverged from their larger counterparts after the crisis. The impact was progressively larger for medium, small, and micro firms relative to large firms. It was also disproportionally larger for firms with limited credit market access. Moreover, smaller firms were less likely to have access to safer banks: those that were better capitalized banks and with a presence in the credit default swap market. Horseraces suggest that firm size may be a more important and robust vulnerability indicator than balance sheet characteristics. Our results imply that the tightening of credit market conditions during the crisis, coupled with limited credit market access especially among micro, small, and medium firms, may have contributed to the large and persistent drop in aggregate TFP.

PENERAPAN METODE BAYES DALAM MENGESTIMASI PREMI RISIKO PADA ASURANSI PENYAKIT KRITIS

The high number of critical illness cases and the rising medical cost affect the number of insurance claimed. It can be a problem for the insurance company in estimating future claim trend to decide the risk premium cost, so that we need a method to solve the problem which is called Empirical Bayes Credibility Theory (EBCT). Based on that information, the goal of this research is estimating the risk premium cost for critical illness cases using EBCT method. In this research, a large simulation of the expected claim data of critical illness policyholders is used, which are grouped by age and gender. In processing data by applying the EBCT method, the credibility factor is determined first, then the size of the risk premium can be estimated, with the calculation results obtained by a different estimate of the risk premium for each age group based on gender.

Fama-French five-factor asset pricing model: empirical evidence from Indian stock market

The present study examines the applicability of five-factor model of Fama-French (2015). This model considers five factors namely market, size, value, profitability and investment in explaining the cross-sectional variations, i.e., variations across different stock or portfolios in the equity returns in Indian stock markets using the monthly closing price data of a sample of 486 companies which are a part of CNX 500 index over the period from July 2000 to June 2015. The paper investigates whether including any or all of the additional four factors can better explain the cross-sectional variations than the single factor capital assets pricing model. The investment strategies based on size, value and profitability provided abnormal returns over the study period. By making use of the Davis et al. (2000) methodology, we find that Fama-French five-factor model based on market premium, size premium, value premium, profitability premium and investment premium explains the variations in the equity returns better than single factor capital assets pricing model but it does not increase the adjusted R2 significantly. The results have implications for asset pricing, market efficiency and investment strategies in the Indian stock market.

A Replicating Portfolio Approach to Valuing American Options in Closed-Form

I derive closed-form expressions for the value of American call and put options (on an asset with continuous yield) using the Feynman-Kac formula, modelling the size of early exercise premium as a function of the strike, dividend yield and time to maturity. Strategies involving European options and binary options on forwards on the asset replicate an American option exactly. Violations of Put-Call parity for American options is also explored in this framework.

Settling the Size Matter

The size premium has failed to materialize since its discovery almost 40 years ago, but is seemingly revived when controlling for quality-versus-junk exposures. This article aims to resolve whether there exists a distinct size premium that can be captured in reality. For the United States, the authors confirm that a highly significant alpha emerges in regressions of size on quality, but for international markets, they find that the size premium remains statistically indistinguishable from zero. Moreover, the US size premium appears to be beyond the practical reach of investors because the alpha that is observed ex post in regressions cannot be captured by controlling for quality exposures ex ante. The authors also find that the significant regression alpha in the United States is entirely driven by the short side of quality. Altogether, these results imply that size only adds value in conjunction with a short position in US junk stocks. However, the authors also show that small-cap exposure is vital for unlocking the full potential of other factors, such as value and momentum. They conclude that size is weak as a stand-alone factor, but a powerful catalyst for other factors. TOPICS:Analysis of individual factors/risk premia, factor-based models, portfolio construction Key Findings ▪ The size premium in the United States becomes significant in regressions that control for quality versus junk, but for international markets, it remains small and insignificant. ▪ The US size premium appears to be beyond the reach of investors because it cannot be captured by controlling for quality-versus-junk exposures ex ante. ▪ Size is weak as a stand-alone factor but a vital catalyst for unlocking the full potential of other factors, such as value and momentum.

Adjustment by size effect on the cost of equity: Pending practice in capital budget in Colombia

This research identifies and analyzes the implications of capital budgeting techniques implemented by large, medium and small companies, related to the use and calculation of the discount rate - emphasizing in the cost of equity, adjusting it with a size premium and the calculation method of the latter- differentiating between the procedure of family and non-family businesses and the types of projects. Additionally, the same procedure is used for the viability indicators of the projects given their relevance in capital budget. For this, a descriptive analysis accompanied by contingency tables is made to a group of 182 Colombian companies. The results show that (i) only 14% of SMEs that evaluate their projects (93) adjust the discount rate with a size premium, (ii) procedures to define capital budget are more informal in family companies, (iii) expansion and replacement projects are more evaluated by family businesses, while mergers and acquisitions are more evaluated by non-family businesses, and (iv) there is little transfer of knowledge from the academy to the company.

The Size Effect: Should We Care?

The Size Effect: Should We Care?

From the Editor

I hope this issue finds you and your families all safe and well during this pandemic. I am very honored with the appointment to editor of the Business Valuation Review. I would like to thank Ken Pia and the Business Valuation Committee for this opportunity. I would also like to thank Victor Jarosiewicz, Roger Grabowski, and Jay Fishman, all past editors, who have coached me and without whom this issue would not be possible. Thanks to Allyson King as well for continuing as Managing Editor and providing so much support through the last few months. My thanks would not be complete without a proper thank you to the editorial review board members and the reviewers that you see on the inside cover of this journal. Before taking on this role, I did not fully appreciate the extent of the Business Valuation Review's double-blind review process and the detail to which our reviewers vet submitted manuscripts. Our reviewers are some of the best and brightest in the profession and reviews are completed in a thorough and professional manner. Our reviewers provide insightful comments to authors based on their own training, research and experiences and provide the comments and insights that lead to an outstanding final product. This issue continues a much-heated debate over total beta and the size premium. I thank Keith Butler, Roger Grabowski, and Anas Aboulamer for their insightful perspectives on the topics. Also, thanks to Joseph Thompson and David Neuzil who provide a framework for testing terminal values which can lead to significant valuation errors.The last several months have brought us extraordinary change, some good, some bad. My condolences go out to all those who have lost friends or family or have otherwise been affected by Covid-19. The current pandemic has changed so much… I live in New Jersey and performed a management interview on March 16. My children's schools were already closed, and they were being instructed remotely. All NJ bars and restaurants were closed effective 8 pm that evening, and I have not performed an on-site management interview since then. By Monday, March 23, the S&P 500 index dropped to a low, down over 30% from December 31, 2019. Many were under mandatory stay at home orders by the end of March. We saw unemployment spike to its highest levels since the Depression, while many local businesses were shuttered. We have seen a resurgence in the stock market indices, but not all businesses have recovered the same way. Zoom (ticker ZM), which has been an amazing tool throughout this pandemic for meetings, interviews, depositions and trials, has seen its stock price soar over 500%, while local restaurants and gyms in my area remained closed and have just opened for inside services in the last few weeks. The pandemic has clearly affected all businesses, but not the same way.I recently saw a meme that read, “the first rule of 2021 is… you don't talk about 2020,” a reference to the 1999 film Fight Club. It may be nice to forget much of what has happened over the last six months, but regardless of our feelings, Covid-19 has had and is going to continue to have a significant impact on the way businesses operate, and in turn, the way we value them. So many factors will affect our valuations, like capacity limitations, state, local and federal regulations, the Payroll Protection Act and the impact of loan forgiveness, any further economic stimulus, and perhaps the risk of additional waves. Our objective at the Business Valuation Review is to:So much has changed in our world in such a short period of time. Much of this change will affect the way we as a profession work and do our work. I would like to make a call out to all the authors and would-be authors reading this to share their thoughts, theories and industry-specific case studies that may be of interest to us all and would contribute to our body of knowledge as a profession. When I started in this business, I read Shannon Pratt's Valuing a Business and the like, which provided a fantastic framework for valuing any business. However, I found myself turning to the Business Valuation Review when I had a novel type of business or perhaps a special situation where art or experience was required to compensate when science fell short. The current economic environment is full of such areas, and I would love to publish articles in these areas in future issues of the Business Valuation Review. Please enjoy the articles in this issue and consider submitting articles that may contribute to the practice of business valuation.Be well,Kyle Garcia

Total Beta—Where Does It Fit in Valuation Theory

The valuation of any company by the discounted cash flow method is divided into two different tasks: forecasting cash flows and discounting these same cash flows using the appropriate discount rate. The latter requires a good understanding of the risks faced by the subject company's cash flows to be able to determine the appropriate risk premia to compensate a typical willing buyer and satisfy a typical willing seller. There is a high level of ambiguity and dispersion of opinions about how to quantify these risks especially when valuing closely held companies. To avoid dealing with the task of identifying and measuring components of the appropriate risk premia for the subject company, some practitioners have turned to a measure that, supposedly, lumps all risks together (which they term Total Beta) and purportedly then allows one to estimate a total cost of equity. The proponents of total beta believe that by using a “total risk” beta there is no need to consider size premia, lack of marketability premia or company specific risk premia. Critics of total beta argue that there is no theoretical basis for total beta as a measure of total risk. This paper argues for the camp of the critics of total beta because we believe it represents a major departure from finance theory and does not adjust the cost of capital correctly for Company Specific Risk. Then, we examine academic research to show that the two major arguments used by total beta proponents to discredit the existing model do not hold. We do not argue that the existing models are absolute truth. We recognize the limitation of the CAPM and/or Modified CAPM models and we admit their inability of answer all questions regarding the cost of equity. However, we believe that total beta is not a step in the right direction.

The Small-Sized Premium: Is It Really Relevant? Evidence from the European Equity Market

The valuation of a company reflects the expected return or equivalently, the cost of capital that investors demand in exchange for the risk assumed. Despite the ex-ante nature of the problem, the majority of empirical analysis has focused on factors explaining expected returns from an ex-post perspective. In this paper, we take a different approach and try to identify which factors are ex-ante included in discount rates, with particular attention to the so-called size premium. Starting from observed market capitalisations and company fundamentals, we obtain the implied cost of capital from the reverse engineering of a carefully designed fundamental valuation model. Panel data regressions are used to investigate the existence of a relation between the implied cost of capital and the firm’s size, including other control variables representative of the most cited asset pricing “anomalies”. Our sample comprises European non-financial stocks listed on primary markets, with half-yearly observations starting from the aftermath of the 2008 global financial crisis. Contrary to common wisdom, we find that the firm’s size has no tangible impact to explain the implied cost of capital.

Size Effect in Indian Equity Market: Myth or Reality?

This study revisits size effect and its associated issues, in the Indian market, as recent studies question the persistence of size premium in the global context. We use data from NIFTY 200 stocks for the period 2005 to 2018 and find size effect to be significant for both market-based and accounting-based measures of size. It is not impacted by any definitional issues as highlighted by Berk (Financ Anal J 53(5):12–18, 1997). Size effect also remains significant despite alternative portfolio constructions i.e. forming quintiles, deciles, scores of portfolios even though the premiums vary. Existing literature on size anomaly does not focus on size drift and survivorship bias. We specifically address these dimensions relating to size effect which have received less attention in prior work. In this study, size effect is found to be sensitive to drift in market capitalization. Historical market capitalization used to categorize medium (large) firms may now be a basis for classifying small (medium) firms in recent time periods. Small sized portfolio adjusted for drift provides substantially higher return compared to unadjusted small sized portfolio. Further, to evaluate survivorship bias, size-based portfolios are redesigned using changing components of NIFTY 200 for each formation period. This leads to considerable weakening of size effect. Investors must take this fact into consideration while creating size based portfolios. However, upon using another stable universe of F&O traded stocks, size effect is found to be significant. The study contributes to size anomaly literature for Indian market and shall be useful for portfolio managers, investors, academia and regulators.

Multifactor Assets Pricing Model: A Review Based Study

Generous consideration has been pursued to the empirical testing of multi factor assets pricing models. However, literature provides mixed kind of evidences in the support of multi factor assets pricing model. This study reviews 20 research articles based on multi factor assets pricing model and examines 25 research papers based on the empirically testing of multi factor assets pricing model published during 2001 and 2018 to study the multi factor assets pricing model in the Indian context as well as foreign context. CAPM is a popular normative model used by researchers to explain the relationship between risk and expected return of a risky asset which was developed by Sharpe (1964) and Lintner (1965). This model takes only one risk factor which is the excess market portfolio return (Market premium). Because of poor performance of CAPM in explaining realized returns, the Fama and French three factor asset pricing model (1993) was developed. Fama and French (1993) documented the size effect and the value effect that were not included in the CAPM, generally known as CAPM anomalies. Mark M. Carhart (1997) developed the Carhart four factor model. It is an extension of the FF three factor model with one another factor i.e. momentum factor effect for asset pricing of stocks. In view of the limitations of the earlier three-factor model, Fama and French five-factor asset pricing model (2014) was developed. Fama and French (2014) came with profitability pattern and investment pattern in average stock return along with the market premium, size premium and value premium. This paper may be an expedient source of information to the academics, financial analyst and researchers to understand the asset pricing model.

STOCK LIQUIDITY PREMIUM ON THE TOKYO STOCK EXCHANGE

The main purpose of this study is to examine whether the liquidity of firms listed on the Tokyo Stock Exchange is priced in Japanese stocks. We investigate the relationships between several types of illiquidity measures and realized stock returns by employing the portfolio formation method. We find that most of the illiquidity measures proposed in the previous literature are positively associated with stock returns. This study also examines the interrelationship among illiquidity measures, return momentum, and historical volatility. Different to the previous literature for Japanese stocks, this study finds that return spreads between illiquid and liquid portfolios are not always positive and statistically significant after controlling firms’ book-to-market ratio. Thus, the liquidity premium overlaps the value premium and size premium in Japan. In addition, different types of illiquidity measures are quite differently related to momentum and volatility. Furthermore, these different associations with volatility and momentum can be explained to some extent by the book-to-market ratio.

Hedging positions in US wheat markets: a disaggregated data analysis

PurposeThis study aims to spot wheat data and disaggregated commitment of trader data for CME traded wheat futures to examine the effect of exogenous shocks for hedging positions of Producers and Swap Dealers on cash-futures basis and excess futures returns.Design/methodology/approachA Bayesian vector autoregression (BVAR) methodology is used to capture volatility transfer effects.FindingsEvidence is presented that institutional short hedging positions play a major role in the pricing of asymmetric information held by Swap Dealers into the basis. The results also indicate that producer hedging contains information when conditions in the supply chain create a shift in long vs short hedging demand. Finally, the results demonstrate that that Swap Dealer short hedging has the greatest effect on risk premium size and historical volatility.Originality/valueVarious proxies for spot prices are used in the literature, although actual spot price data is not common. In addition, stationarity for basis and open interest data is induced using the Baxter-King filter which allows us to work with levels, rather than percentage changes, in the time series data. This provides the ability to directly observe the effect of outright open interest positions for hedgers on contemporaneous innovations in basis and in excess returns. The use of a BVAR methodology represents an improvement over other structural VAR models by capturing contemporaneous systemic effects within an endogeneity based structural framework.

Value and patience: The value premium in a dividend-growth model with hyperbolic discounting

We show that in a consumption-based asset-pricing model with hyperbolic discounting - leading to dynamically inconsistent time preferences - the value premium increases nonlinearly with the degree of discounting and thus affects the cross section of returns. To test our model empirically, we relate the size of the value premium in 41 countries to the degree of hyperbolic discounting across those countries. The latter was found in an International Test of Risk Attitudes (INTRA). Our result is robust to the inclusion of other variables from INTRA, such as risk aversion, as well as micro- and macro-economic variables from the 41 countries.

Settling the Size Matter

The size premium has failed to materialize since its discovery almost forty years ago, but is seemingly revived when controlling for quality-versus-junk exposures. This paper aims to resolve whether there exists a distinct size premium that can be captured in reality. For the US we confirm that a highly significant alpha emerges in regressions of size on quality, but for international markets we find that the size premium remains statistically indistinguishable from zero. Moreover, the US size premium appears to be beyond the practical reach of investors, because the alpha that is observed ex post in regressions cannot be captured by controlling for quality exposures ex ante. We also find that the significant regression alpha in the US is entirely driven by the short side of quality. Altogether, these results imply that size only adds value in conjunction with a short position in US junk stocks. However, we also show that small-cap exposure is vital for unlocking the full potential of other factors, such as value and momentum. We conclude that size is weak as a stand-alone factor but a powerful catalyst for other factors.

Increasing Corporate Bond Liquidity Premium and Post-Crisis Regulations

I employ the corporate bond liquidity premium to understand the important changes in corporate bond market liquidity from 2004 to 2019. I show that while commonly-used transaction cost measures such as the bid-ask spread have been declining, the corporate bond liquidity premium has actually increased since the financial crisis. For speculative bonds, about 30% of their yield spread now compensates for illiquidity compared to 15% before the crisis. I demonstrate that this increasing liquidity premium is due to investors facing longer trading delays as dealers have become less willing to provide immediacy, and develop a structural over-the-counter model to estimate the latent trading delays implied by the size of the liquidity premium. The estimation results suggest that bonds that took less than one day to sell before the financial crisis now take weeks to trade. Finally, I establish a causal relationship between the major post-crisis regulations and the variations in the corporate bond liquidity premium to uncover the potential cause of dealers' unwillingness to provide liquidity. I show that Basel II.5, by introducing the stressed value-at-risk and incremental risk charges for credit products, contributed the most to increasing the liquidity premium out of all regulatory changes examined. The longer trading delays and the impact of regulations are consistent with practitioners' descriptions of the post-crisis market and corroborate the relevance of using the liquidity premium to understand corporate bond market liquidity.

Green Premium: What is the Implied Prognosis for Sustainability?

Economic considerations underpin almost every decision to determine social priorities. It is not surprising then that sustainability has fast become, among other things, economic advocacy. This has led to a proliferation of studies to establish the provenance of a green premium to provide impetus for sustainable real estate development to drive the sustainability agenda. The extant literature is replete with studies that conclude that green buildings, which are a proxy for sustainable real estate, command a green premium, notwithstanding disagreement about the size of the green premium. We revisit the green premium debate by analyzing Building Research Establishment Environmental Assessment Method (BREEAM) certified office buildings (a proxy for green buildings) in the Greater London area to ascertain the prevalence of a green premium and to answer the following questions: is the premium truly green (green-magic)? What prognosis does the green premium provide for sustainability? The study uses quantitative analysis (a hedonic model to analyze 2,842 CoStar transaction data points from 2008 to 2018 inclusive) and psychographic analysis based on primary data from a questionnaire survey of approximately 450 BREEAM certified building owners and occupiers in the Greater London area to address the research questions. The preliminary results of the hedonic model analysis show that BREEAM certification commands a rental and price premium of 4.3% and 22.3% respectively. Furthermore, the results reveal that a higher certification level generally generates a higher premium while certified buildings in outer zones generate a higher premium than those in the CBD. In addition, the results of both the quantitative and psychographic analyses imply that the premium is more a novelty premium than green-magic. This portends a dismal prognosis for sustainability and warns that sustainability cannot be won on purely economic grounds. Finally, the results of the psychographic analyses show that there is no meeting of minds (consensus ad idem) between investors in green office buildings on one side and green office space users (tenants) on the other. The results of the study could be of interest to London green office building market participants, researchers, practitioners, and sustainability adherents.

Small and Vulnerable: Small Firm Productivity in the Great Productivity Slowdown

We provide broad-based evidence of a firm size premium of total factor productivity (TFP) growth in Europe after the Global Financial Crisis. The TFP growth of smaller firms was more adversely affected and diverged from their larger counterparts after the crisis. The impact was progressively larger for medium, small, and micro firms relative to large firms. It was also disproportionally larger for firms with limited credit market access. Moreover, smaller firms were less likely to have access to safer banks: those that were better capitalized banks and with a presence in the credit default swap market. Horseraces suggest that firm size may be a more important and robust vulnerability indicator than balance sheet characteristics. Our results imply that the tightening of credit market conditions during the crisis, coupled with limited credit market access especially among micro, small, and medium firms, may have contributed to the large and persistent drop in aggregate TFP.

Moment risk premia and the cross-section of stock returns in the European stock market

Abstract This article investigates whether volatility, skewness, and kurtosis risks are priced in the European stock market and assess the signs and the magnitudes of the corresponding risk premia. To this end, we adopt two approaches: a model-free approach based on swap contracts, and a model-based approach built on portfolio-sorting techniques. A number of results are obtained. First, stocks with high exposure to innovations in implied market volatility (skewness) exhibit low (high) returns on average. Second, the estimated premium for bearing market volatility (skewness) risk is negative (positive), robust to the two approaches employed, and statistically and economically significant. Third, in contrast with studies on the US stock market, we identify the existence of a size premium in the European stock market: small capitalization stocks earn higher returns than high capitalization stocks.