Proxy for other factors: A host of papers argue that the bulk or all of the small size effect can be attributed to a liquidity effect and that putting in a proxy for illiquidity makes the size effect disappear or diminishes it. 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? Given the shaky base on which it is built and how much that base has been chipped away in the last two decades, you would think that analysts would reconsider their use of small cap premiums, but there are three powerful forces that keep it in play. Market capitalization and illiquidity don’t always go hand in hand, since there are small, liquid companies and large, illiquid ones in the market.
That is no longer the case and there are studies that categorize companies based on measures of illiquidity (bid ask spread, trading volume) and find an “liquidity premium” for illiquid companies. 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? 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. 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 trendy boutique s on January 1, 2015 was 7.95% in the US (yielding an overall equity risk premium of 5.78% on that day). 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.