Cost of Equity for Private Companies: How to Calculate It (With a Worked Example)

You've memorized CAPM. Risk-free rate plus beta times equity risk premium, done. Then an interviewer asks: "How would you calculate the cost of equity for a private company?" and suddenly there's no stock price, no beta, and no market cap to work with.

The short answer: you borrow betas from comparable public companies, strip out their leverage, re-apply the private company's leverage, and then layer on extra premiums for size and risk. This post walks you through each step, a full worked example, and how to explain it cleanly in an interview.

Why Private Companies Break the Usual CAPM Approach

For a public company, cost of equity is mostly a lookup exercise. You pull a regression beta from Bloomberg, grab the risk-free rate, plug in an equity risk premium, and you're there.

A private company has none of the market data that makes this easy:

• No beta: there's no stock price history to regress against the market.
• No market value of equity: so you can't compute a market-based debt-to-equity ratio.
• More risk that CAPM ignores: private companies are usually smaller, less diversified, more dependent on a few customers or a founder, and their shares are hard to sell.

So you need workarounds. There are two main ones bankers use: the comparable companies beta approach and the build-up method.

Method 1: Borrow and Adjust Betas From Public Comps

This is the approach you should lead with in an interview. It keeps you inside the CAPM framework but fixes the missing-beta problem.

Step 1: Pick Comparable Public Companies

Find public companies in the same industry with similar business models. A private regional HVAC services company should be compared to public HVAC and building services firms, not to a diversified industrial conglomerate.

Pull each comp's levered beta, debt-to-equity ratio (market values), and tax rate.

Step 2: Unlever Each Comp's Beta

A comp's observed beta reflects both its business risk and its financial risk from debt. You want only the business risk, so you remove the effect of leverage.

The most common formula (Hamada) is:

Unlevered Beta = Levered Beta / (1 + (1 − Tax Rate) × D/E)

Step 3: Take the Median (or Average)

Once all comps are on the same unlevered basis, take the median of their unlevered betas. The median is usually preferred because one weird comp won't skew the result.

Step 4: Relever at the Private Company's Capital Structure

Now you add back financial risk using the formula in reverse:

Relevered Beta = Unlevered Beta × (1 + (1 − Tax Rate) × D/E)

Here's the catch: which D/E do you use? The private company has no market value of equity. You typically use:

• A target capital structure (what the company or buyer plans to run with), or
• The industry median D/E from the comps.

Using the private company's book equity is generally a bad idea, since book equity can be wildly different from what the equity is actually worth.

Step 5: Plug Into CAPM

Cost of Equity = Risk-Free Rate + Relevered Beta × Equity Risk Premium

Then, because private companies carry risks CAPM doesn't capture, you often add premiums on top (more on that below).

Worked Example: Cost of Equity for "PrivateCo"

Let's put real numbers through the process. All market inputs here are illustrative assumptions for teaching purposes, not current market data.

Assumptions:

• Tax rate: 25% for all companies
• Risk-free rate: 4.0%
• Equity risk premium: 5.5%
• PrivateCo target D/E: 40%

Unlevering the Comps

Notice something useful: Comp C looked much riskier with a 1.40 beta, but after removing its heavy leverage, its business risk is close to the others. That's exactly why we unlever.

Median unlevered beta: 0.980

Relevering for PrivateCo

Relevered Beta = 0.980 × (1 + 0.75 × 0.40) = 0.980 × 1.30 = 1.274

CAPM Cost of Equity

Cost of Equity = 4.0% + 1.274 × 5.5% = 4.0% + 7.0% = 11.0%

Adding Private Company Premiums

Now suppose PrivateCo is small and heavily reliant on its founder and two large customers. You might add:

• Size premium: 3.0%
• Company-specific risk premium: 2.0%

Adjusted Cost of Equity = 11.0% + 3.0% + 2.0% = 16.0%

That jump from 11% to 16% matters a lot. In a DCF, a higher discount rate can meaningfully lower the valuation, which is why these premiums get debated hard in real deals.

The Extra Premiums, Explained

Size Premium

Historically, smaller companies have delivered higher returns than CAPM alone would predict, and practitioners interpret this as compensation for extra risk. Valuation firms publish size premium data grouped by company size, and appraisers often reference these tables.

Interview tip: Mention that the size premium is widely used in practice but debated in academic circles. That nuance shows you understand it's a judgment call, not a law of physics.

Company-Specific Risk Premium (CSRP)

This covers risks unique to the business:

• Customer concentration (one client is 40% of revenue)
• Key person risk (the founder is the company)
• Weak financial reporting or unaudited statements
• Limited access to capital

There's no formula for this one. It's purely judgment, which is why it's also the most attacked number in any private company valuation.

What About Illiquidity?

Private company shares are hard to sell, and investors want compensation for that. But be careful: in valuation practice, illiquidity is often handled as a discount on the final value (a discount for lack of marketability), not as an add-on to the cost of equity.

The key rule: don't count it twice. If you bake illiquidity into a higher discount rate and apply a marketability discount at the end, you've punished the valuation for the same risk two times.

Method 2: The Build-Up Method

The build-up method skips beta entirely and stacks premiums on top of the risk-free rate. It's common in valuations of small private businesses where good public comps are hard to find.

Cost of Equity = Risk-Free Rate + Equity Risk Premium + Size Premium + Industry Risk Premium + Company-Specific Premium

Using illustrative numbers:

• Risk-free rate: 4.0%
• Equity risk premium: 5.5%
• Size premium: 3.0%
• Industry risk adjustment: 1.0%
• Company-specific premium: 2.0%

Cost of Equity = 15.5%

Notice there's no beta here. Implicitly, it assumes a beta of 1.0 and then adjusts for industry risk with a separate premium.

When to mention it: If the interviewer pushes with "What if there are no good public comps?" this is your answer.

Bonus Concept: Total Beta

Here's one that can impress in a more technical interview. Standard beta only measures market risk, because it assumes investors hold diversified portfolios. But the owner of a private company often has most of their wealth tied up in that one business. They're not diversified.

The total beta approach, popularized by NYU professor Aswath Damodaran, adjusts for this:

Total Beta = Market Beta / Correlation of the comps with the market

Using our example, if the comps' correlation with the market is 0.40:

• Total Beta = 1.274 / 0.40 = 3.185
• Cost of Equity = 4.0% + 3.185 × 5.5% = 21.5%

That's much higher, which makes sense for an undiversified owner. But if the likely buyer is a diversified public company or a large fund, the standard beta is usually more appropriate. The right cost of equity depends on who the buyer is.

Common Mistakes to Avoid

• Using book equity for D/E. Book values rarely reflect true equity value. Use a target or industry structure.
• Forgetting to unlever. Averaging levered betas mixes different capital structures and gives you a meaningless number.
• Double counting illiquidity. Pick one place to handle it: the discount rate or a final discount.
• Stacking premiums without justification. Every percentage point needs a reason you can defend.
• Choosing lazy comps. A beta is only as good as the companies it came from.

How to Answer This in an Interview

Keep it structured and under a minute. Something like:

"Since a private company has no trading history, I can't observe its beta directly. So I'd find comparable public companies, unlever their betas to remove the effect of their capital structures, take the median, and relever it using the private company's target or industry-average capital structure. Then I'd plug that into CAPM. Because private companies tend to be smaller and riskier, I'd likely add a size premium and possibly a company-specific premium. If there aren't good comps, I could use a build-up method instead."

Then stop. Let them ask follow-ups on the formula, the D/E choice, or the premiums. Each of those follow-ups is a chance to show you know the details covered above.

The Bottom Line

The cost of equity for a private company is CAPM with borrowed inputs and extra adjustments. Borrow betas from comps, unlever and relever them, apply CAPM, and add justified premiums for size and company-specific risk.

Master the unlever-relever math, know where illiquidity belongs, and you'll turn one of the trickier technical questions into an easy win.