When it comes to valuing a business, size matters. The main reasons for this is that companies of different sizes face very different risks. Most investors believe that large companies are less risky than their small counterparts. Other things being equal, the smaller firms need to generate higher returns to compensate their investors for the extra risk they take.
How much more risk? The largest Fortune 500 firms with market capitalizations approaching $500M are about as risky as the overall market. On the other hand, for businesses that are valued well below $150M, the investors currently demand the additional risk premium of around 9.5%. That’s the bracket where most small businesses fit in.
Here are some reasons for this risk perception difference:
- Large companies have better access to debt and equity capital.
- Larger firms tend to be more diversified in their product and service offering.
- Small companies usually have a relatively limited market reach.
- Large firms with deep pockets are often preferred by customers who look for a stable, long-term vendor.
- Large companies have an easier time attracting top management and skilled talent.
How company size affects its value
To illustrate, we will use the well-known Build-Up model to calculate the capitalization rate for a fictitious Fortune 500 company and a small business. We will assume that both firms are debt-free and their earnings grow at 5% per year. Both companies are in the general merchandize retail industry, SIC 5399.
|Company||Cap rate||Valuation multiple|
|Small private firm||20.0%||5.0|
In this example we have included the company specific risk premium of 4% for both firms.
The valuation multiples above tell a remarkable story: the large company commands the valuation ratio that is almost twice as high as its small business counterpart!
In other words, it takes almost $2 of business earnings for the small company to contribute as much to its value as $1 for the Fortune 500 firm.