Understanding the Build-Up Method

Dec 21, 2020Business, Business Valuation

When valuing a business, experts use various valuation methods, such as Discounted Cash Flows (DCF) analysis, comparable company analysis, market value, and asset-based methods. When using DCF method, one way to select an appropriate discount raWhen valuing a business, experts use various valuation methods, such as Discounted Cash Flows (DCF) analysis, comparable company analysis, market value, and asset-based methods. When using the DCF method, one way to select an appropriate discount rate for the business is to use the build-up method.  

How Do you Use the Build-up Method?

Article Contents
  • Risk-Free Rate (Safe Rate)
  • Equity Risk Premium (ERP)
  • Size Premium
  • Industry Risk Premium (IRP)
  • Company-Specific Risk Factors

Risk-Free Rate
+ Equity Risk Premium (ERP)
+ Size Premium
+/- Industry Risk Premium
+ Specific Company Risk
= Cost of Capital Discount Rate*

* Does not take into account for beta

Helpful Definitions

  1. Risk-Free Rate (Safe Rate)
    • The most commonly used measure is the 20-year yield on a U.S. Treasury Bond.
    • Can consult Wall Street Journal quoted market yields on a 30-year bond with approximately 20 years of maturity left.
  2. Equity Risk Premium (ERP)
    • Premium is needed for investors to participate in equity markets instead of long-term governmental securities.
    • Many valuation analysts use a long-term horizon with the S&P 500 as their benchmark.
    • This Premium is forward-looking and represents the anticipated incremental return on common stocks.
    • Uses historical excess return on stocks over the long-term government bond income returns.
    • The basic premise is that past ERP is a reasonable forecast for future ERP.
  3. Size Premium
    • Size Premium = increased risk in small companies.
    • These are presented for each of the 10th decile of the public securities market.
    • Reflect the excess returns required on small securities.
    • The increased risk maybe developed by many criteria related to the subject company to help determine the size premium.
  4. Industry Risk Premium (IRP)
    • The amount investors expect the future return of the industry to exceed the return on the market.
    • This amount is often leveraged for the industry beta.
  5. Company-Specific Risk Factors
    • Final component of the discount rate.
    • The most judgmental area of business valuation.
    • Includes risks associated with the industry operated in as it relates to the economy.
    • It also relates to the subject company’s risks, including management, market, and suppliers and customers’ concentration risks.
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