The Entrepreneur’s Cost of Capital: Incorporating Downside Risk in the Buildup Method

Capital Asset Pricing Model (CAPM) suggests that an investor’s cost of equity capital is determined by beta, a measure of systematic risk based on how returns co-move with the overall market. We propose to replace beta with downside beta, a measure more consistent with investors’ perception of risk. Recent empirical evidence suggests that downside beta better captures the risk-return relationship in both emerging markets and developed markets. Grouping companies into industries by two-digit SIC code, we show that the average downside beta can be very different from traditional beta. The authors discuss the implications of using downside beta on valuation, and provide a simple example to illustrate the application in valuation for both diversified and un-diversified investors.