The Build-Up Method for Cost of Equity
When a company is too small, too private, or too illiquid for a meaningful beta, appraisers build its cost of equity from a stack of separately-estimated premiums instead of a single regression coefficient.
Prerequisites: Bottom-Up Beta from Comparable Companies
CAPM answers "how much return should this stock's risk demand?" with one multiplier: beta, applied to the market's overall risk premium. That works well for a large public company with years of trading history. It works much less well for a small, closely-held business with no stock price to regress against at all, and where a big chunk of its real risk — small size, thin management bench, a single dominant customer — isn't well captured by a single market-wide beta in the first place.
The build-up method, common in private-company and small-business appraisal, sidesteps needing a beta entirely. It builds the required return as a sum of separately-justified risk premiums, stacked on top of the risk-free rate.
Instead of one number (beta) scaling one premium (the market risk premium), the build-up method adds several distinct premiums side by side — market risk, size risk, and sometimes company-specific risk — each estimated from its own body of evidence. It trades CAPM's elegance for the ability to price risks a beta can't see.
The stack
In words: start with the risk-free rate, add the overall equity risk premium (compensation for market risk generally), add a size premium (small companies have historically demanded higher returns than large ones, even after controlling for beta), and add a company-specific risk premium for anything unique to this business — customer concentration, key-person dependence, lack of a trading market for its shares.
Each term is estimated independently: the equity risk premium from long-run market history, the size premium from published studies grouping public companies into size deciles and measuring the extra return small-cap stocks have historically earned, and the company-specific premium from the appraiser's own judgment about that particular business's idiosyncratic risks.
Worked example
A small private manufacturing business is being valued. The risk-free rate (a long-term government bond yield) is 4.0%. The long-run equity risk premium is estimated at 5.5%. Published size-premium studies suggest micro-cap companies of this size have historically earned an extra 4.0% above what CAPM alone would predict. The appraiser also adds a 3.0% company-specific premium, reflecting that 60% of this company's revenue comes from a single customer.
A cost of equity of 16.5% is far higher than a typical large-cap CAPM estimate (which might land around 9-10%), and that gap is the point: this small, customer-concentrated, illiquid business genuinely carries risks that a market-index beta was never going to capture.
What this means in practice
The build-up method is standard in business valuation for estate and gift tax appraisals, buy-sell agreements, and small-business M&A, where there is no stock price to regress and the company's specific risks are exactly what a buyer is worried about. It's rarely used for large, liquid public companies, where CAPM with a proper beta is both more standard and better supported by data.
The company-specific risk premium is the most subjective term in the stack, entirely at the appraiser's discretion, and is the most common place for a valuation to be quietly pushed toward a predetermined conclusion. Always ask what specific evidence justifies that number, not just that one was included.
Further reading
- Pratt & Grabowski, Cost of Capital: Applications and Examples (ch. on the build-up method)