Definition
The build-up method estimates cost of equity by adding individual risk premiums to the risk-free rate, rather than using CAPM's beta-based approach. Components typically include equity risk premium, size premium, industry premium, and company-specific risk premium. This method is common for private company valuations where beta cannot be observed.
functions Formula
Ke = Rf + ERP + Size Premium + Industry Premium + Company-Specific Risk
lightbulb Example
Risk-free rate 4% + equity risk premium 6% + small-cap premium 3% + industry premium 1% + company-specific risk 2% = 16% cost of equity for a small private company.
verified_user Key Points
- Alternative to CAPM for private companies
- Builds return from individual risk components
- More subjective than CAPM
- Common in business valuation and litigation contexts