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Build-Up Method of Valuation
In the “buildup method” valuation begins with the risk-free rate. The individual valuing the firm then makes the subjective determination of what percentage to add to the risk-free rate. The amount added depends upon the amount of risk associated with the business earnings. The value of the firm is calculated by dividing the adjusted earnings by the determined capitalization rate. The buildup method is frequently used in small and medium-size businesses where comparisons to publicly traded company betas are not deemed to be applicable or it is felt they should be supplemented. The equation for this method can be written as follows:
Re = Rf +ERP + Rs + Rc
where
Re = Expected rate of return of the company
Rf = Risk-free rate of return
ERP = Equity risk premium
Rs = Size premium
Rc = Specific company risk
The risk-free rate is generally the U.S. Treasury note rate. The equity risk premium may be obtained through a number of professional publications. The size risk premium accounts for the increased risk associated with investing in smaller firms. The company-specific risk is a subjective determination based upon the characteristics of the subject firm. The types of items usually considered include: Management depth, Management expertise, Access to capital, Leverage, The five Porter threats, Product diversification, Geographic distribution, Demographics, Availability of labor, Employee stability, Economic factors, Fixed asset age and condition, Distribution system, Location, Technological risk, Socio-cultural risk, Political risk, Global risk, Size.
The individual valuing the firm will assign values to each of these aspects in developing a risk factor. Taken together, these considerations allow for the determination of a discount rate. As previously stated, the estimated growth rate is subtracted from the discount rate to determine the capitalization rate.