What Is the Size Premium?
Academic research going back to Rolf Banz's 1981 study found that small-cap stocks have historically earned returns above what their betas would justify under CAPM. The size premium captures that excess: investors appear to demand extra compensation for the risks that come with smaller scale, including thinner liquidity, less diversified revenue, weaker access to capital, and higher sensitivity to economic downturns.
The premium is measured empirically by sorting public companies into size buckets, historically the CRSP deciles by market capitalization, and comparing each bucket's realized returns to its CAPM-predicted returns. The smaller the decile, the larger the observed gap, with the smallest micro-cap groupings showing premiums of several percentage points.
How It Is Applied
The size premium enters through a modified CAPM, often called the build-up method: Cost of Equity = Risk-Free Rate + Beta x Equity Risk Premium + Size Premium, sometimes with a further company-specific risk premium for private businesses. Practitioners source the premium from published datasets, most prominently the Kroll (formerly Duff & Phelps) Cost of Capital studies, matching the subject company's size to the appropriate decile or portfolio.
Magnitudes scale inversely with size. A mid-cap company might warrant well under 1%, while businesses in the smallest deciles can justify premiums in the 2% to 5% range or higher. For a small private company with a 4% risk-free rate, 1.0 beta, 5% ERP, and a 3% size premium, the cost of equity lands at 12% rather than the 9% plain CAPM would produce.
Why It Matters and the Ongoing Debate
Adding even a few points to the discount rate materially lowers a valuation, so the size premium is one of the most consequential judgment calls in valuing small and private companies. It appears routinely in fairness opinions, estate and tax valuations, purchase price allocations, and litigation support, where appraisers must document the specific dataset and decile behind the number they used.
The premium is also genuinely contested. Researchers have noted that the small-cap effect weakened considerably after its publication, that much of it concentrates in the very smallest and least liquid stocks, and that some argue it compensates for liquidity rather than size itself. Analysts should be prepared to defend why they included or excluded it, since sophisticated audiences will press on exactly that point.
