How to Calculate Cost of Equity for a Private Company

For a private company, the usual approach is the build-up method: start with the risk-free rate, add the equity risk premium, then add premiums for size, industry and risks specific to the business. With a 5% risk-free rate, 5% equity risk premium, 3% size premium, 0% industry adjustment and 2% company-specific premium, the cost of equity is 15%.

The other common approach is to borrow betas from similar public companies, adjust them for your company’s debt, and run a modified version of CAPM. Both are covered below. The Private company tab of the cost of equity calculator uses the build-up method.

Why private companies need a different method

CAPM needs a beta, and beta comes from a history of share price returns. A private company has no traded shares, so there’s nothing to measure.

Private companies also tend to be smaller and less diversified than the public companies CAPM was built around. They often depend on a handful of customers or one owner, and their shares can’t be sold quickly. Investors want to be paid more for all of that. The methods below add those premiums explicitly.

The build-up method

The build-up method stacks one premium on top of another:

Ke = Rf + ERP + Size premium + Industry premium + Company-specific premium

Component	Example	What it covers
Risk-free rate	5%	Return on a government bond
Equity risk premium	5%	Extra return for owning stocks in general
Size premium	3%	Extra return small companies have historically needed
Industry premium	0%	Adjustment if the industry is riskier or safer than average
Company-specific premium	2%	Risks unique to this business
Cost of equity	15%	Sum of the above

There’s no beta in the formula. The method assumes a beta of 1.0 for the market portion, then uses the industry premium to adjust up or down if the industry is more or less risky than the market.

Risk-free rate and equity risk premium

These are the same inputs used in CAPM. The risk-free rate comes from the Treasury’s daily par yield curve. For the equity risk premium, Kroll recommends 5.0% for the US, used with the higher of a 3.5% normalized risk-free rate or the spot 20-year Treasury yield.

Size premium

The size premium reflects the long-observed pattern that small public companies have earned higher returns than large ones, beyond what their betas would predict. Valuation firms publish size premium data broken out by company size.

The premium is measured on small public companies, and most private businesses are smaller still. That’s one reason appraisers often add a company-specific premium on top.

Industry premium

Some build-up models include an industry adjustment for sectors that are riskier or safer than the market. In the site example it’s 0%, meaning the industry is treated as average risk. A cyclical industry might get a positive number. A stable one might get a negative number.

Company-specific risk premium

The company-specific risk premium is the most subjective piece. It covers risks particular to this business that the other premiums don’t. Things appraisers commonly look at:

• Customer concentration (one customer making up a large share of sales)
• Dependence on the owner or one employee
• Short or uneven earnings history
• Thin management team
• Weak financial reporting or unaudited books
• Supplier concentration
• Pending legal or regulatory issues

There’s no table that converts these into a number. The premium is a judgment, and it should be explained in writing. Typical premiums run from zero for a well-run company with few concentrations to several points for a fragile one.

Worked example: build-up

A small regional distribution business, owner-managed but with a solid second-in-command and a fairly spread customer base:

Step 1. Risk-free rate: 5%.

Step 2. Add the equity risk premium: 5% + 5% = 10%.

Step 3. Add a 3% size premium: 13%.

Step 4. Industry is about average: add 0%. Still 13%.

Step 5. Add a 2% company-specific premium for owner dependence and some customer concentration: 15%.

The cost of equity is 15%. Compare that with 11% for the site’s CAPM example of a listed company with a 1.2 beta. The 4-point gap is the size and company-specific premiums at work.

The comparable company approach

If you’d rather use beta, you can borrow it from similar public companies. The steps:

1. Find a group of public companies in the same industry. Damodaran’s betas by industry page is a common shortcut, since it lists average levered and unlevered betas by sector.
2. Unlever their betas to remove the effect of their debt.
3. Relever the average using your company’s target debt-to-equity ratio and tax rate.
4. Plug the result into CAPM and add size and company-specific premiums.

The relevering uses the Hamada equation:

Levered beta = Unlevered beta x (1 + (1 - tax rate) x D/E)

Say the industry’s unlevered beta is 0.9, your company’s target debt-to-equity is 0.5, and the tax rate is 21%:

0.9 x (1 + 0.79 x 0.5) = 0.9 x 1.395 = 1.2555

Then add the premiums:

Ke = 5% + 1.2555 x 5% + 3% + 2%
   = 5% + 6.28% + 3% + 2%
   = 16.28% (rounded)

That’s a little higher than the 15% build-up result because the relevered beta of about 1.26 says this industry, at this debt level, is riskier than the market average. The build-up example assumed average industry risk.

The guide on levered vs unlevered beta goes through unlevering and relevering in more detail.

Why private company rates are higher

Private companies usually end up with a higher cost of equity than public companies of the same type. The reasons:

• They’re smaller, and size carries a premium.
• Owners are often undiversified. Much of their wealth sits in one business.
• Shares are hard to sell. There’s no exchange and few buyers.
• Information is weaker. Financials may be unaudited and forecasts less reliable.
• Key-person and customer risks are more common.

A higher rate means a lower valuation for the same cash flows. That’s how the market prices the extra risk. The FAQ on what increases cost of equity covers the general drivers.

Common mistakes

Watch for these when building a private company rate:

• Double counting. If the size premium already captures small company risk, don’t add the same thing again inside the company-specific premium.
• Using a public company beta without adjusting for debt. A comparable with no debt and one with heavy debt have very different betas.
• Mixing pre-tax and after-tax cash flows. The cost of equity applies to after-tax cash flows to owners.
• Forgetting the debt side. If the business has meaningful debt, you’ll also need a WACC to value the whole company.

Using the number

The 15% figure is the return an outside investor would need to buy into this business. It’s the discount rate for cash flows to equity holders and a reasonable hurdle rate for new projects funded by the owners.

If the business has no meaningful debt, cost of equity and WACC are the same. If it does, combine them as shown in the WACC guide. The methodology page explains how the calculator handles each premium.