In business valuation, determining the cost of equity is one of the most crucial components of the overall cost of capital. Arguably, it is most important to get this right when valuing a business - especially for purchase. The cost of equity depends on many factors including the business size, the industry, the economic environment, but also the ability to buy or sell shares in the business, also known as ‘liquidity’. There are two primary approaches to determining the equity cost of capital. The first is the Beta Method arising from the Capital Asset Pricing Model (“CAPM”). The second is the Buildup Method which relies on the identification of specific factors.

What Is the Beta Method when calculating the cost of equity? The Beta Method is widely used to estimate the cost of equity for public companies, relying on a measure of the stock’s volatility compared to the overall market. The Capital Asset Pricing Model (CAPM) describes a method to quantify risk and determine the expected return for investment in an equity security. CAPM suggests that there is both unsystemic risk and systemic risk in a company. Unsystemic risk is the risk a company faces that is unique to that particular company. Systemic risk applies to all companies in a market and is related to broad economic and market conditions. CAPM quantifies systemic risk in the stock market (Rm) by measuring the performance over time of the stock market using the TSX 300 Index or S&P 500 Index in comparison to a risk free investment (Rf) like a treasury bill or other government issued debt security, over the same period.

The Buildup Method Explained The Buildup Method calculates the cost of equity by combining multiple individual risk factors, making it especially useful for private business valuations. The primary components typically included in the Buildup Method are the Risk-Free rate (Rf), the equity Market risk (Rm) plus an Industry risk premium (Ri) and a Size premium for small businesses (Rs). Lastly, the Buildup Method allows for Company Specific Risks like customer concentration, liquidity, and operational factors. (Rcsr). Check our article on How to Calculate Discount Rates for Business Valuation for a detailed discussion on the Buildup Method. at https://troyvalue.com/how-to-calculate-discount-rates-for-business-valuation/ The Buildup Method provides flexibility for private company valuations by making direct adjustments for unique risks a market-driven Beta often overlooks.

Key Differences Between Beta and Buildup While both Beta and Buildup methods aim to quantify equity risk, they differ significantly in approach and suitability depending on the business type. These differences are summarized below:

Beta Data Source:

  • trading history of the shares of the company, and
  • trading history of the applicable market index Applicability:
  • Public companies
  • Can be used for a very large private company if a suitable proxy can be discovered Flexibility: Formula driven with little room for creative enhancements Transparency: While this method relies on public market data, the mathematics to determine equity market risk and beta are complex and not suitable for many readers.
    Buildup Data Source:
  • identification, determination and support for the individual risk components Applicability:
  • Private companies
  • Can be used for very thinly traded small cap companies Flexibility: Allows for specialized selection of suitable input variables for customized risk assessments Transparency: Explicit justification and support of selection of input variables provides clarity in analysis and review

Why the Buildup Method is Often Better for Private Businesses Private businesses, particularly smaller ones, often face unique risks due to factors like size, revenue concentration, and liquidity limitations. For instance, they might rely heavily on a few customers, suppliers, or product lines, increasing exposure to potential disruptions. Smaller businesses may be unable to seek financing when needed due this higher risk and often lower-valued tangible assets. Many small businesses are reliant of the personal goodwill of the owner leading to greater risk upon transaction.

Application of public market data to private companies may not be reliable due to the absence of trading history. There is no method to observe the change in equity value of a private company relative changes in a market index. This lack of data makes the calculation of reliable beta impossible.
The Buildup Method is better for valuations of private business as it allows for the valuer to identify the specific risks facing that business and quantify those risks.

When to Use Beta vs. When to Use Buildup for calculating the cost of equity When undertaking a valuation, the preferred method would be to use Beta for public companies or when a comparable market can be directly referenced. Use Buildup Method for private companies, especially smaller firms, or those without market-traded shares. For small businesses with limited access to market data, the Buildup Method will produce a more reliable and defendable valuation.

Best Approach for Calculating Cost of Equity Business valuation is strongly related to the present value of future cash flows. Getting the cost of capital right is dependent on selecting the right method for calculating the cost of equity. The method used to determine the cost of equity impacts the overall business valuation accuracy.
The Beta Method relies on public market data. It is directly suitable for valuations of public companies. The Buildup Method enables a valuer to identify and quantify specific risk factors and is suitable for private companies. Read our article on How to Calculate Discount Rates for Business Valuation for a detailed discussion on discount rates and the Buildup Method. Understanding these valuation tools is key for business owners, accountants, and lawyers who want accurate, context-relevant valuations.

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