Forecasting size premium for small company valuation

You can value just about any company using a number of income-based business valuation methods. These methods require that you provide two key inputs:

• Estimate of business earnings, usually in the form of cash flow
• A factor representing business risk such as the discount or capitalization rate

An example of business valuation based on income is the discounted cash flow method. To use this technique, you would project the business earnings over a number of years into the future. Then, you would need to provide an assessment of business risk by calculating or building up the discount rate.

One of the elements that make up the discount rate is the so-called company size premium. Larger firms tend to be less risky while smaller companies entail greater risk. So you can expect the discount rate for a smaller business to be a bigger number. Since the discount rate appears in the denominator in the valuation calculation, the value of a smaller company is lower for the same level of earnings compared to a larger competitor.

If you take a peek at the discount rate build-up formula, you will see the company size premium being included. How are these numbers determined? You can calculate the size premia from returns of publicly traded companies taken over a period of time, say a year.

Smaller companies will tend to generate greater returns to compensate the investors for the higher risk. You can compile returns for a group of companies of a certain size, usually measured by market capitalization. The additional returns provided by a group of companies in a certain market cap range give you an idea of the company size premium.

This is in fact how the calculation of the company size premia is done. The data can be arranged in a table giving you a measure of additional size premium for a given company market capitalization.

So far so good. You can read off the company size premium and come up with a discount rate to use in your business valuation. But what if the company you are valuing is smaller than the smallest publicly traded companies?

Since it is not easy to find reliable data on returns for very small private companies, you can try using the data you have to estimate the size premium for your target firm.

One way to do this is to use extrapolation. You base your estimate on the known numbers then use the so-called linear regression calculation, available in a typical spreadsheet program, to estimate the size premium for your size company.

For example, in Excel this calculation is performed using the Forecast formula. You specify the company market cap, presumably smaller than the range of capitalizations you have available from existing data. The desired number is calculated for you using the known values of company size premia and market capitalizations.

Example – estimating size premium for a small private firm

As an example, we would like to come up with a size premium to value a private company whose equity value is under $10,000,000. Let’s pick a few starting numbers for our estimate first.

As you can see from the table, the lowest market cap number we have available is $50M, much larger than our $10M target firm. To get the estimate we need, we use the table data as the starting point and apply the Forecast model to get an estimate at a new market cap, namely $10M. Here is the result:

16.52%

This is over two percentage points higher than the size premium measured for companies in the $50M market cap range. How much difference can this make to your business valuation result? Consider the following scenario of future cash flows for the business over the next 5 years:

Let’s say that the company terminal value at the end of the forecast is $10M. Using the 25% discount rate gives us the business value of $4,819,584. If the discount rate is reduced by two percentage points to 23% the business value rises to $5,165,073.

Valuing a business by discounting its cash flow

See an example of how to value a company of any size by discounting its cash flow while properly accounting for business risk.

Excess earnings method: how the rates of return affect the business value

If you are valuing an established business the capitalized excess earnings method is an excellent choice to determine the value of business goodwill. However, use care when specifying the rates of return as your results may vary considerably.

The method uses not one but two rates of return to calculate the valuation results. One is the rate of return on the business’ net tangible assets. The other is actually the capitalization rate used to calculate the value of business goodwill from earnings.

Depending on your valuation scenario the choices of these rates can make a surprisingly big difference. To demonstrate, we select the following inputs for the excess earnings valuation:

• Annual business earnings (net cash flow): $100,000
• Expected earnings growth rate, per year: 5%
• Cash on hand: $10,000
• Accounts receivable: $5,000
• Inventory: $25,000
• Other current assets: $2,000
• Property and equipment: $30,000
• Other fixed assets: $2,000
• Rate of return on net tangible assets: 30%
• Accounts payable: $3,000
• Other current liabilities: $1,000

Under the above assumptions we get these results:

• Value of business goodwill: $331,800
• Total business value: $401,800

Now let’s see how the results change if we assume a 20% growth in annual business earnings:

• Value of business goodwill: $948,000
• Total business value: $1,018,000

The difference is remarkable. A closer look shows that most of the business value increase is due to goodwill. The cap rate used to calculate it is the difference between the fair rate of return on net tangible assets and the earnings growth rate. This is the business cap rate and it went from 25% (30% – 5%) in the initial scenario down to just 10% for the second calculation.

In simple terms, we expect the business earnings to grow at 4 times the initial rate. Without changing the other inputs this means that the company is expected to growth much more rapidly while facing the same level of business risk.

If you are an investor, you basically assume that the management has figured out a way of generating much better earnings while keeping the risk the same. This is a big strategic difference and it shows in the much greater business value result.

Note that the excess earnings method depends to a great extent on your choices for the rates of return. In the calculations above we used the overall company discount rate and cap rate. You can see how the discount rate is typically calculated for a business using the build up formula. The cap rate then is just the difference between the discount rate and the earnings growth percentage per year.