Know What A Company Is Worth: Using Business Rules of Thumb

 

Determining the value of a business can be complex, especially if you’re dealing with incomplete financial data or the business is in a unique niche. However, business rules of thumb—general guidelines or shortcuts can help provide a quick, preliminary estimate of a company’s worth. These simplified methods are not replacements for formal valuation techniques but can be helpful in getting a rough sense of a business’s value, making them great starting points for buyers, sellers, and investors.

In this expanded post, we’ll explore common business rules of thumb, their applications, and limitations, and provide a more comprehensive understanding of how they can be used effectively.

 

What Are Business Rules of Thumb?

A business rule of thumb is a widely accepted principle or shortcut based on industry averages, historical data, and general trends. These rules are used to estimate a business’s value without exhaustively analyzing its financials. They’re handy in scenarios where time constraints, limited access to information, or early-stage evaluations require quick estimates.

While they offer a helpful framework, it’s essential to remember that rules of thumb are guidelines rather than absolute rules. They can vary widely based on industry, location, business size, and economic conditions. Let’s look at some common business valuation rules of thumb used by entrepreneurs, business brokers, and investors.

 

1. Revenue Multiples

One of the most straightforward business rules of thumb involves applying a revenue multiple to a company’s annual sales. This approach assumes that businesses in similar industries with comparable sales volumes can be valued using a consistent multiple.

For instance, if the industry standard multiple is 2x annual revenue, a business generating $500,000 in sales would be valued at around $1 million (2 x $500,000). The revenue multiple varies significantly between industries. High-growth industries like technology might use higher multiples, while lower-growth industries like retail might use lower ones.

Pros:

• Simple and quick calculation.
• Useful for businesses with predictable and steady revenue.

Cons:

• Does not consider profitability. A business with high revenue but low profit might be overvalued using this method.
• Revenue multiples can fluctuate based on economic conditions, making this approach less reliable during downturns.

 

2. Earnings Multiples (EBITDA Multiples)

Unlike revenue multiples, earnings multiples focus on a company’s profitability, often using EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) as a critical metric. This rule of thumb assumes that businesses are valued as a multiple of their cash flow or earnings capacity.

For example, if a business has an EBITDA of $200,000 and the industry-standard multiple is 5x, its estimated value would be $1 million (5 x $200,000). Earnings multiples tend to provide a more accurate reflection of a business’s financial health because they account for its ability to generate profits.

Pros:

• Considers profitability, making it a more accurate reflection of business performance.
• It is widely used in mergers and acquisitions, making it a well-recognized valuation method.

Cons:

• Requires accurate financial data. If the financials are poorly maintained, this method can be misleading.
• Does not consider factors like future growth potential or risks.

3. Asset-Based Valuation

In some cases, a company’s value is best assessed by its tangible assets, such as inventory, equipment, and real estate. This method is beneficial for asset-heavy businesses like manufacturing or retail.

For instance, a retail business might have $300,000 worth of inventory, $200,000 in equipment, and $100,000 in real estate, giving it an estimated value of $600,000 based purely on its assets. This rule of thumb is often used when the business’s financials are unclear, or when its assets are the primary value drivers.

Pros:

• Provides a conservative estimate based on tangible, easily measurable assets.
• It is useful for liquidation scenarios where the value of assets is the primary concern.

Cons:

• Ignores intangible assets like brand value, customer relationships, or intellectual property, which can be significant in many businesses.
• May undervalue service-based businesses that rely on expertise rather than physical assets.

 

4. Owner’s Discretionary Cash Flow (ODCF)

The Owner’s Discretionary Cash Flow (ODCF) is a popular rule of thumb for small businesses. This method estimates the value based on the cash flow available to the owner after accounting for discretionary expenses like personal benefits, one-time expenses, and non-operational costs.

A typical multiple for ODCF might range from 2x to 4x, depending on factors like industry stability, location, and the competitive landscape. For example, if a business has an ODCF of $150,000 and an average multiple of 3x, its estimated value would be $450,000.

Pros:

• It considers the actual cash flow the owner can extract, which is crucial for buyers.
• Simple and commonly used for smaller, owner-operated businesses.

Cons:

• Heavily dependent on accurate adjustments for discretionary expenses, which can be subjective.
• It may not fully account for future growth opportunities or risks.

 

5. Industry-Specific Rules of Thumb

Certain industries have unique valuation methods based on specific metrics relevant to their operations. These industry-specific rules of thumb leverage the sector’s particular characteristics and economics.

For example:

• Restaurants are often valued using a multiple of their annual sales, typically between 0.5x and 1x.
• Accounting firms might be valued based on a percentage of their annual billable hours or recurring client contracts.
• Construction companies could be valued based on a multiple of their backlog of contracted projects.

Pros:

• Tailored to the unique aspects of the industry, providing a more accurate valuation for niche businesses.
• Often used by industry insiders familiar with these specific benchmarks.

Cons:

• It may not be applicable outside of the specific industry, limiting its use.
• It can be outdated if the industry undergoes significant changes or disruptions.

 

When to Use Business Rules of Thumb

Business rules of thumb are a great starting point for estimating a company’s value, especially when quick decisions are needed or in early-stage discussions. However, these methods should be supplemented with more detailed valuation techniques, such as discounted cash flow (DCF) analysis or a market-based approach, to provide a more accurate picture.

It’s also advisable to consult with a professional with experience appraising businesses whenever money is at risk. They can provide a thorough analysis incorporating quantitative and qualitative factors, giving you a clearer understanding of the business’s worth.

 

 

Final Thoughts

While business rules of thumb are valuable tools for estimating value, they should never be the sole method to determine a company’s worth. They help get a rough estimate but overlook important factors influencing value, such as market conditions, industry trends, and specific risks. We offer a free guide if you need information regarding the sale of a business. You can download it by clicking here.

Need help determining the value of a business? At Bizprofitpro, we offer comprehensive valuation services and expert guidance tailored to your needs. Use this link to book a free, confidential consultation. We adhere strictly to privacy policies and ensure your information is handled in strict confidence.