How would you estimate the cost of equity for a small private company using the build-up method, and why add a size premium?
A core Valuation interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
The build-up method constructs the cost of equity by stacking risk premia: risk-free rate + equity risk premium + size premium + company-specific (unsystematic) risk premium, sometimes plus an industry adjustment. It's used when there's no reliable beta because the company is private and small with no clean comparables. The size premium is added because empirical evidence (e.g., long-run small-cap studies) shows smaller firms have historically earned returns above what CAPM beta alone predicts — they're riskier in ways beta misses: less diversification, key-person dependence, thinner access to capital. So a pure CAPM understates the required return for a small private firm, and the build-up's size and specific-risk premia correct for it. The judgement risk is the company-specific premium.
WHAT INTERVIEWERS LISTEN FOR
- ✓Stack: risk-free + ERP + size + specific (+industry)
- ✓Used when no reliable beta/comparables
- ✓Size premium captures empirical small-firm excess return
- ✓CAPM alone understates small-private cost of equity
COMMON MISTAKES
- ✗Using plain CAPM for a small private firm
- ✗No size or specific-risk premium
- ✗Treating the specific premium as precise
Reading isn't the same as answering under pressure.
Interviewers don't hand you the model answer — you deliver yours on a clock. Practice this and 1,000+ questions with AI feedback on every answer.
RELATED QUESTIONS
- What happens to the DCF value if you increase WACC by 1%?
- How do you calculate Beta for a private company?
- Should you use mid-year or year-end convention in a DCF?
- How do you handle negative cash flows in a DCF?
- What discount rate would you use for a highly leveraged company?
- A company has negative working capital because it collects cash from customers upfront but pays suppliers later. How does this affect your DCF valuation, and what trap must you avoid when projecting free cash flows?