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Financial News

Fortnightly Magazine - October 15 1995

Does the size of a company affect the rate of return it should earn? If smaller companies should earn a higher return than larger firms, then small utilities, because of their size, should be allowed to adjust the rates they charge to customers.By far the most notable and well-documented apparent anomaly in the stock market is the effect of company size on equity returns. The first study focusing on the impact that company size exerts on security returns was performed by Rolf W. Banz. Banz sorted New York Stock Exchange (NYSE) stocks into quintiles based on their market capitalization (price per share times number of shares outstanding), and calculated total returns for a value-weighted portfolio of the stocks in each quintile. His results indicate that returns for companies from the smallest quintile surpassed all other quintiles, as well as the Standard & Poor's 500 and other large stock indices. A number of other researchers have replicated Banz's work in other countries; nevertheless, a consensus has not yet been formed on why small stocks behave as they do.

One explanation for the higher returns is the lack of information on small companies. Investors must search more diligently for data. For small utilities, investors face additional obstacles, such as a smaller customer base, limited financial resources, and a lack of diversification across customers, energy sources, and geography. These obstacles imply a higher investor return.

The Flaw in CAPM

One of the more common cost of equity models used in practice today is the capital asset pricing model (CAPM). The CAPM describes the expected return on any company's stock as proportional to the amount of systematic risk an investor assumes. The traditional CAPM formula can be stated as:

Rs = [bs x RP] + Rf


Rs = expected return or cost of

equity on the stock of

company "s"

b = the beta of the stock of

company "s"

RP = the expected equity risk


Rf = expected return on a riskless


Table 1 shows beta and risk premiums over the past 69 years for each decile of the NYSE. It shows that a hypothetical risk premium calculated under the CAPM fails to match the actual risk premium, shown by actual market returns. The shortfall in the CAPM return rises as company size decreases, suggesting a need to revise the CAPM.

The risk premium component in the actual returns (realized equity risk premium) is the return that compensates investors for taking on risk equal to the risk of the market as a whole (estimated by the 69-year arithmetic mean return on large company stocks, 12.2 percent, less the historical riskless rate). The risk premium in the CAPM returns is beta multiplied by the realized equity risk premium.

The smaller deciles show returns not fully explainable by the CAPM. The difference in risk premiums (realized versus CAPM) grows larger as one moves from the largest companies in decile 1 to the smallest in decile 10. The difference is especially pronounced for deciles 9 and 10, which contain the smallest companies.

Based on this