CNXT earnings are right around the corner. It is entirely possible that you are an idiot savant with the uncanny capacity to assess the right discount rate for companies, but if that is the case, why go through this charade of using risk and return models and adding premiums to get to your “intuited” discount rate? If illiquidity is what you are adjusting for in the small cap premium, why is it a constant across companies, buyers and time? Even if your defense is that the small cap premium is an imperfect (but reasonable) measure of the illiquidity premium, it is unreasonable to expect it to be the same for every company. Works only with market cap: Finally, you can take issue with the use of a market-priced based measure of size in a study of returns. Market capitalization and illiquidity don’t always go hand in hand, since there are small, liquid companies and large, illiquid ones in the market.
While the results are interesting and can be used by active small-cap fund managers as a justification for their activity, they are in no way a basis for adding a small cap premium to every small company, and asking analysts to add it on only for small, high quality companies is problematic. Conexant Systems Inc. (CNXT) – Conexant Reports Financial Results for First Quarter of Fiscal 2011 – CNXT traded flat Wednesday. So what? If your argument for the small cap premium is that small cap the boutique s are riskier, you now have the onus of explaining why that risk shows up only in the first month of every year. An argument can be made that R&D expense is a capital expense, not an operating one, and that it should treated as such. If your argument is that size is a good proxy for illiquidity, that all small companies are equally illiquid and that that illiquidity does not change as you make them bigger, why are you reducing your end value by an illiquidity discount? The current market rate of interest on the Caldwell bonds is 8.45%. What is the current market price (intrinsic value) of the bonds? Four decades ago, your excuse would have been that the data on illiquidity was either inaccessible or unavailable and that market capitalization was the best proxy you could find for illiquidity.
If illiquidity is your bogey man in valuation, why use market capitalization as a stand-in for it? In effect, to the extent that my base year cash flows are reasonable and my expected growth rate reflects market expectations, the expected return on large cap stocks on January 1, 2015 was 7.95% in the US (yielding an overall equity risk premium of 5.78% on that day). Thus, if you are using a 30% expected growth rate on your company, your “small” company is getting bigger (at least according to your estimates) and presumably more liquid over time. In any valuation, you assume through your company’s cash flows and growth rates that your company will change over time and it is inconsistent (with your own narrative) to lock in an illiquidity premium into your discount rate that does not change as your company does. Furthermore, the premium you add to the discount rate should be higher in some periods (during market crises and liquidity crunches) than others and for some buyers (cash poor, impatient) than others (patient, cash rich). In effect, the market is attaching a smaller expected return for small cap stocks than large ones, stories and intuition notwithstanding.
After all, if the proponents of small cap premiums are right, bundling together small companies into a larger company should instantly generate a bonus, since you are replacing the much higher required returns of smaller companies with the lower expected return of a larger one. Put simply, if small cap stocks are viewed by investors as riskier and that risk is being priced in, you should expect to see, other things remaining equal, higher expected returns on small cap stocks than large cap stocks. You could also write a article related to the product you are promoting, and in the authors box, put a link to the product, and then submit it to some article directories, and make money that way around. The tightness of the liquidity screen can then be varied to fit your liquidity needs as an investor. If the historical data ceases to support the use of a historical risk premium, can we then draw on intuition and argue that since small companies tend to be riskier (or we perceive them to be), investors must require higher return when they invest in them? In summary, if the only justification that you can offer for the addition of a small cap premium to your discount rate is the historical risk premium, you are on thin ice.
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