How do investors decide what return they deserve for taking a risk on a company? At the heart of every business valuation lies one crucial number, the Cost of Equity. It represents the return investors expect for putting their money into a business instead of a risk-free asset.
But in India, where reliable market data is limited and private companies dominate, valuers often turn to a pragmatic and transparent tool, the Build-Up Method.
Build-Up Method
The Build-Up Method does exactly what its name suggests, it builds up the cost of equity step by step by adding various layers of risk.
It typically starts with the risk-free rate (like yield on 10-year Government of India bonds), and then adds premiums for: - Equity Risk Premium (ERP): the extra return for investing in equities over risk-free bonds. - Size Premium: smaller companies are riskier, so investors demand more return. - Industry or Sector Premium: sectors like technology or real estate may carry additional volatility. - Company-Specific Risk Premium (CSRP): this reflects unique risks such as customer concentration, management depth, or governance quality.
Example: If the 10-year government bond yield is 7%, and total risk premiums add up to 9%, the total Cost of Equity = 16%. This “built-up” rate becomes a critical input in Discounted Cash Flow (DCF) valuations, helping determine the fair value of a business.
Insights from Valuation Standards
International Valuation Standards (IVS) and ICAI Valuation Standards (VS 103) both recognize the Build-Up Method as one of the most professional yet judgment-driven tools for valuers. However, valuers should consider the following while applying it: - Data Sources Matter: Indian valuers often rely on RBI bond yields, Bloomberg data, and Duff & Phelps ERP studies. The chosen benchmarks must be relevant to the valuation date. - Size Premium in Indian Context: ICAI guidance notes highlight that smaller, unlisted companies, typical in India’s SME and startup ecosystem, deserve a higher size premium due to limited access to capital and liquidity. - Professional Judgment is Key: IVS and ICAI both warn against arbitrary premiums. Each component must be justified, ideally by past performance, peer data, or sectoral benchmarks. - Integration with DCF Models: The Build-Up rate directly affects discount rates, influencing valuation outcomes significantly. Even a 1% change in cost of equity can shift valuation by 5–10%.
Together, these insights reinforce that the Build-Up Method is not just a calculation, it’s a story of risk translated into numbers.
In India’s dynamic market, the Build-Up Method remains one of the most adaptable and transparent ways to estimate the cost of equity, especially for unlisted or privately held firms.
It reminds us that valuation is not about perfection, but about reasoned judgment backed by consistent methodology. When done right, it bridges the gap between market perception and professional analysis, helping investors and businesses make informed, defensible decisions.
How do you estimate the right risk premiums for private companies in your valuations? Share your thoughts below!