One of the common questions in valuing businesses of different sizes we hear often:
Are there differences in value between companies of different sizes? If so, how does the difference factor into business valuation?
The fact is that when it comes to business valuation, size matters. This makes intuitive sense if you spend a bit of time checking out the behavior of investors in the public capital markets.
Investors tend to be far more demanding if the company they invest in is smaller. Larger companies, on the other hand, tend to have an easier time attracting investors content with lower returns.
Why such difference? The simple answer is risk. Indeed, it is common knowledge that smaller firms tend to be more risky than their larger counterparts. Big companies have more resources, are usually better diversified in their product offerings, play in a number of markets and have well trained and highly compensated management and key employees.
Well managed large companies use these advantages to produce more predictable, steady earnings over time. Since the essence of investor risk is uncertainty, dependable earnings are valued highly.
For each dollar of investor money, smaller companies generally need to show greater returns than the well established larger competitors. In the language of business appraisal all this points toward value increase as the company size grows.
One of the ways this difference in value can be captured is in the discount rate. If you take a look at how the discount rate is calculated, you will notice that one of the elements is company size premium.
The smaller the company, the greater the size premium. Since the discount rate appears in the denominator of business valuation calculations, such as the discounted cash flow method, the effect is to reduce the business enterprise value.
How much of a difference does size make? As it turns out, quite a bit. The largest multi-billion dollar firms may require the size premium in the 1% – 2% range. Compare this with the smallest companies with market cap at or below $100M that can have a size premium of well over 10%.
To put this in perspective imagine a very large and a very small company in the same industry sector. The capitalization rate for the large firm may be 25% whereas the small company value calculation will call for a cap rate of 35% or so.
For each $1M in capitalized earnings the difference in value will be:
- Large company: $4M
- Small company: $2.86M
That’s a value difference of some 40%.
So for a given level of earnings, the company size premium will tend to reduce the business value. This is consistent with the market demand for greater returns from smaller companies.
The same logic applies to capitalization rates since they are derived directly from the discount rate for the company. Use caution when working with valuation multiples derived from business sales comparables. These multiples must account for the size of company you value correctly. In other words, the sample of business sales you use to come up with your valuation multiples must include companies whose size is about the same as the company you value.