Business valuation and equity risk premium
If you are valuing a private company, one of the key elements of the appraisal is assessment of the business risk. You can quantify your risk assessment as the discount or capitalization rates. To calculate these rates use any number of the cost of capital models such as the build-up or CAPM.
Regardless of the model you use, you will notice that they rely upon the estimation of the so-called equity risk premium. This risk element captures the overall uncertainly as to the size and timing of returns from a diversified portfolio of public company stock investments.
You can use such public capital markets information to assess the risk of a privately owned business. Prudent investors rely on the public market data to make decisions on investment in a public or private company. They will invest in a given company if the returns they receive are commensurable with the risk. So the equity risk premium is an opportunity cost that the business owners incur to attract and retain the much needed capital for their business.
Along with the risk-free rate of return, the equity risk premium sets the lower limit on any privately owned company discount rate. In other words, smart investors will not put their money into a company unless the returns they get match or exceed the sum of the current risk-free return and the equity risk premium.
Usually, risk associated with a privately owned company will also include such elements as its size, the industry sector it operates in, and a set of company specific risk factors.