Valutico supports the calculation of the Cost of Equity using two primary approaches: the Capital Asset Pricing Model (CAPM) and the Build-up Method.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a widely used approach to estimating the Cost of Equity. It is based on the concept of systematic (market) risk i.e. the risk inherent to the entire market that cannot be diversified away. Since rational, diversified investors are not compensated for unsystematic risk, CAPM incorporates only systematic risk in its calculation. In practice, however, analysts often extend the model by adding a Company-Specific Risk Premium (CSRP) to reflect unsystematic risks unique to the business.
The formula for CAPM is:
Where:
rf: Risk-free rate
βₑ: Levered Beta
MRP: Market Risk Premium
CSRP: Company-Specific Risk Premium or Cost of Equity Premium
Pros and Cons of CAPM
Pro: CAPM helps to ground the Cost of Equity in market data, providing consistency and comparability across different companies.
Con: Beta is often unreliable for small private companies, as it is based on public market data that may not reflect their unique risks.
Build-up Method
The Build-up Method avoids reliance on beta by estimating the Cost of Equity as the sum of the risk-free rate and various risk premiums. It is considered a more granular alternative to CAPM and is a commonly used approach in the US.
The formula for the Build-up Method is as follows:
re = rf + Equity Risk Premium + Country Risk Premium + Industry Risk Premium + Size Risk Premium + Company Specific Risk Premium
This method is primarily used when obtaining a reliable beta estimate for the CAPM is difficult, such as for small private businesses.
Pros and Cons of the Build-up Method
Pro: The Build Up Method directly addresses unsystematic risk through the inclusion of multiple risk premiums, providing a detailed breakdown of risk components.
Con: The risk premium component is highly subjective and requires robust justification for its quantification.
Switching between CAPM and Build Up Method
Navigate to the Cost of Capital Module
Select the applicable approach to calculate cost of equity using the drop-down menu
Application of Valuation Methods
When using the Build-up Method to determine the Cost of Equity, following valuation methods on the platform become unavailable.
DCF WACC
DCF APV
Flow-to-Equity
The above-mentioned methods are incompatible because they rely on a beta-based dynamic cost of capital, which is not a part of the Build-up Method's calculation.
Other valuation methods including DCF WACC - Simplified, Simplified Flow-to-Equity, Dividend Discount Model and Capitalized Earnings remain available.