market—about 3 to 3.5 percent when we look at the
1926–2004period.Thispracticecanbedangerousforthree
reasons.Thefirst isthat thesmallfirmpremium hasbeen
volatileanddisappearedforanextendedperiodinthe1980s.
Thesecondisthatthedefinitionofasmallmarketcapstock
variesacrosstimeandthatthehistoricalsmallcappremiumis
largely attributable to the smallest (among the small cap)
stocks.Thethirdisthatusingaconstantsmallstockpremium
adjustmentremovesanyincentivethattheanalystmayhave
toexaminetheproductcharacteristicsandoperatingleverage
of individual small market cap companies more closely.
Private and Closely Held Businesses
Implicit in the use of beta as a measure of risk is the
assumption that the marginal investor in equity is a
well-diversified investor. While this is a defensible
assumptionwhenanalyzingpubliclytradedfirms,itbecomes
muchmoredifficulttosustainforprivatefirms.Theownerof
a private firmgenerally hasthe bulk ofhis or her wealth
investedinthebusiness.Consequently,heorshecaresabout
thetotalriskinthebusinessratherthanjustthemarketrisk.
Thus,foraprivatebusiness,thecostofequityestimatedusing
a market beta will understate the risk. There are three
solutions to this problem:
- Assume that the business is run with the near-term
objectiveof saleto a largepubliclytraded firm.Insucha
case,itisreasonabletousethemarketbetaandcostofequity
that comes from it.
2.Addapremiumtothecostofequitytoreflectthehigher
riskcreatedbytheowner’sinabilitytodiversify.Thismay