How to Calculate Cost of Equity Using Build Up Method
While CAPM is the go-to model for calculating the cost of equity in public markets, it relies heavily on data like beta and market returnβwhich aren't always available for private companies.
Enter the Build-Up Method: a practical, additive approach to estimate required return when traditional inputs are missing or unreliable.
The Build-Up Method adds layers of risk premiums to a base rate (usually the risk-free rate or a long-term bond yield) to reflect various types of investment risk.
Typical Formula
CostΒ ofΒ Equity=Rfβ+EquityΒ RiskΒ Premium+SizeΒ Premium+IndustryΒ RiskΒ Premium+Company-SpecificΒ Premium
- Risk-Free Rate (Rfβ): baseline return for a riskless investment, e.g., a 10-year Treasury bond;
- Equity Risk Premium: compensation for investing in equities over risk-free assets;
- Size Premium: additional return demanded by investors for holding smaller companies, which tend to be riskier;
- Industry Risk Premium: adjusts for volatility and cyclicality in specific sectors;
- Company-Specific Premium: custom adjustment for non-systematic risks like management quality, client concentration, or governance.
- Valuing private businesses with no beta or trading data;
- When comparables are unreliable or inconsistent;
- In early-stage startup valuation or low-liquidity contexts.
The Build-Up Method helps bridge the gap where data is scarce. It's not as elegant or theoretically grounded as CAPM, but it's practical, flexible, and widely used in private equity, valuation firms, and financial consulting.
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While CAPM is the go-to model for calculating the cost of equity in public markets, it relies heavily on data like beta and market returnβwhich aren't always available for private companies.
Enter the Build-Up Method: a practical, additive approach to estimate required return when traditional inputs are missing or unreliable.
The Build-Up Method adds layers of risk premiums to a base rate (usually the risk-free rate or a long-term bond yield) to reflect various types of investment risk.
Typical Formula
CostΒ ofΒ Equity=Rfβ+EquityΒ RiskΒ Premium+SizeΒ Premium+IndustryΒ RiskΒ Premium+Company-SpecificΒ Premium
- Risk-Free Rate (Rfβ): baseline return for a riskless investment, e.g., a 10-year Treasury bond;
- Equity Risk Premium: compensation for investing in equities over risk-free assets;
- Size Premium: additional return demanded by investors for holding smaller companies, which tend to be riskier;
- Industry Risk Premium: adjusts for volatility and cyclicality in specific sectors;
- Company-Specific Premium: custom adjustment for non-systematic risks like management quality, client concentration, or governance.
- Valuing private businesses with no beta or trading data;
- When comparables are unreliable or inconsistent;
- In early-stage startup valuation or low-liquidity contexts.
The Build-Up Method helps bridge the gap where data is scarce. It's not as elegant or theoretically grounded as CAPM, but it's practical, flexible, and widely used in private equity, valuation firms, and financial consulting.
Thanks for your feedback!
