The “How-to-Ways” of Calculating Cost of Equity for Privately-held Firms

For this article, we cover the topic of Cost of Equity, and more specifically, “how” the cost is calculated for privately-held firms.

By definition…

“the Cost of Equity is the financial return that a company must offer its shareholders to compensate them for the risk of investing in the company.”

This cost represents the compensation investors expect for putting their capital at risk and is a key metric for both investors and companies to evaluate the financial health and risk of equity investments.

Cost of Equity: Private vs. Public

Research clearly shows there is a difference in the cost between privately-held and publicly-listed firms. If a firm is private, its cost will usually be “higher” primarily due to the increased risk associated with their smaller size, illiquidity, and limited access to capital markets. Investors expect to be compensated with a higher return for taking on these greater risks.

While challenging due to the lack of publicly traded stock and reliable Beta (β), private companies can estimate their cost of equity by considering unique risk factors and using adjusted models like the “Build-up method,” which adds premiums for various risks and the “Capital Asset Pricing Model” (CAPM), which uses comparable public companies to estimate a company’s Beta.

(1)    The Build-up approach

The Build-up approach allows for quantifying the specific risks of a private business and adding them to a base rate.

The general formula is:

Cost of Equity (Ke) = Rf + ERP + IRP + SP + CSRP

Where:

• Risk-free rate (R_f) is the return on a long-term, low-risk investment, such as U.S. Treasury bonds.

• Equity risk premium (ERP) is the additional return investors demand for investing in the stock market instead of a risk-free asset. It can be estimated using historical data or surveys of market participants.

• Industry risk premium (IRP) is an adjustment for the additional risk associated with a particular industry, such as regulatory requirements, market volatility, economic cycles, competition, industry beta.

• Size premium (SP) reflects the higher expected returns of smaller companies compared to larger ones, acknowledging their greater risk and typically lower liquidity. The SP can be estimated using data from various sources, including the Fama-French model, which is a multi-factor model that is an expansion of the Capital Asset Pricing Model (CAPM).

• Company-specific risk premium (CSRP) is an additional premium, which is subjective, to account for risks unique to the individual company.

• Factors that might influence the CSRP include product quality, customer concentration, supplier dependence, operational dependency, financial leverage, etc.

Example: The Treasury department of Baur Manufacturing needs to determine the cost of the firm’s equity for a potential IPO.

Using the services of a professional accounting firm, the firm found the following data to estimate its cost of equity.

•         Risk-free rate (yield on 10-year Treasury bonds as of Oct 2, 2025)         4.094%

•         Equity risk premium (historical average)                                                   3%

•         Industry risk premium (based on industry data)                                       0.5%

•         Size premium (based on medium-cap data)                                            2%

•         Company-specific risk premium (based on company analysis)              1%

Cost of Equity                                                                                      10.594%

(2)    Capital Asset Pricing Model (CAPM)

As mentioned above, the other way is to use CAPM.

The formula is:  

Cost of Equity (Ke) = Rf + β(Rm – Rf)

Where:

• Risk-free rate (Rf) is the return on a long-term, low-risk investment, such as U.S. Treasury bonds.

• Beta coefficient (β) measures the sensitivity of an individual security to the market. Higher the sensitivity of the stock, higher the Beta. Beta can be used to assess the riskiness of an investment/project.

A Beta of 1 means the asset's price tends to move with the market, a beta greater than 1 indicates it's more volatile and amplifies market movements, while a Beta less than 1 suggests it's less volatile than the market.

• Market Rate of Return (Rm) is the performance percentage of a market, usually measured by a broad stock market index like the S&P 500, over a specific period, reflecting profits or losses on investments.

Finding a Beta coefficient (β) for a Privately-held Company

If you own stock in a publicly-listed company, finding the rate of return of a company is not that difficult.

For my classes, I use Apple computer (AAPL) as a good example of doing this. The process consist of….

First, using Yahoo! Finance, we found Apple’s Beta was 1.09.

Next, using a 10-year Treasury Bond as the risk-free rate, the rate was 4.094% (also found using the Yahoo! Finance website).

Finally, we found the Equity Market Risk Premium (Rm – Rf) to be 5% (according to KROLL, a global independent valuation services firm).

Based on this information, Apple’s Cost of Equity (Ke) = 4.094% + 1.09(5.0%)

Ke = 9.544% 

This cost of 9.544% represents the minimum rate of return that Apple Computer must generate to satisfy its shareholders.

The issue for privately-held companies is that they do not have a published Beta (β), like what we found for Apple computer.

How do we calculate a Beta for Private Companies?

For this, we can use a modified CAPM to find a Beta. Once we have a Beta, we can then use the CAPM formula to get a cost. This is a 5-step process, consisting of…

Step 1: Identify Comparable Public Companies

Find a group of publicly traded companies in the same industry. These are your "comparable companies."

Step 2: Obtain their Equity Betas

Find the Equity Betas (βe) for these comparable companies, which can be found on financial websites, like Yahoo! Finance, or through databases.

Step 3: Unlever the Betas 

Remove the impact of each company's debt to find their Asset Beta (βa) or Unlevered Beta. The purpose of unlevering a Beta is to isolate the firm’s pure business risk.

The formula is:

βa = βe x [Ve / (Ve + (Vd (1-T)))]

Where:

Be = Equity Beta.

T = tax rate for each comparable company.

Ve = value of the firm’s equity

Vd = value of the firm’s debt

Step 4: Calculate the Average Asset Beta (βa)

Determine the average of these Asset Betas to represent the industry's average asset risk.

Step 5: Relever the Beta

Adjust this average Unlevered Beta to reflect the private company's specific debt and equity ratios to find its unique geared.

The formula is:

βe = βa x [(Ve + (Vd (1-t))) / Ve]

This is your estimated beta for the private company, reflecting its market risk.

Continuing our example of Baur Manufacturing, the company’s CEO and board wants its treasury department to find a cost of equity for the firm using CAPM so it is able to compare the two methods. Finding this cost is particularly important because it helps determine the company's valuation and the share price, ensuring the IPO is attractive to investors while still meeting the company's financing goals.

Example: Earlier, we found using the Build-up approach, Baur calculated its cost of equity to be roughly 10.6%. A member of the treasury department suggested using CAPM as well to compare the two methods. The 5-step process is…

Step 1: Identify Comparable Public Companies

Baur identified four companies (Enterprises A, B, C, and D) similar to Baur regarding revenue, size, products…

Step 2: Obtain their Equity Betas 

Enterprise A –                                 1.4

Enterprise B –                                 1.32

Enterprise C –                                2.4

Enterprise D–                                 2.12

Step 3: Unlever the Betas 

Using the formula βa = βe x [Ve / (Ve + (Vd (1-T)))], the Unlevered Betas of the four companies were calculated to be:

Enterprise A  –                               1.2      

Enterprise B –                                 1.08    

Enterprise C –                                0.71

Enterprise D –                                0.78

Step 4: Calculate the Average Unlevered Beta (of the 4 companies) 

Average Unlevered Beta =        0.9425

Step 5: Relever the Beta

Note: Baur's expected Debt/Asset ratio is 40%.

Using the formula βe = 0.9425 x [(60 + (40 (1-30%))) /60]

βe = 1.3823

So… the new cost of equity for Baur is:

Ke = 4.094% + 1.3823 (5%)

Ke = 11.0%

Analysis: Comparing the two methods, Build-up method vs. CAPM, the Build-up method gave a cost of 10.6%, whereas CAPM was 11%. Based on this, we can say the equity cost of Baur Manufacturing would be in the range of 10.6% to 11%.

Next

My next article is going to be about “how to get a firm’s weighted cost of capital” (WACC) and then how this can be used to “value a privately-held company.”