Take a look at your thumb. Now compare your thumb to another person’s thumb. There are differences in size, shape, manicure, strength, and flexibility between these two thumbs. Remember this comparison, as we will come back to it at the end of this article.
A Rule of Thumb is a brief measurement, typically based on a specific part of the operations of a business, such as revenues or some other easily calculated income stream, including Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The application of a rule of thumb includes some basic math, usually multiplying the selected source of income by a range of numbers.
Each industry, or type of business, usually has three or more different valuation rules of thumb that could potentially be applied to it. This means there are literally thousands of different rules of thumb that are available to provide indications of value for different types of businesses.
Rule Of Thumb Method
, compiled by Tom West and published by Business Brokerage Press. This book is updated every year and includes over 800 pages of descriptions of different types of businesses and franchises, and the various valuation rules of thumb that industry experts have used over the years.
Note the last rule of thumb listed. It illustrates an important point. Imagine a practice with $1, 000, 000 of annual collected revenues. According to that rule of thumb, the practice could sell for between $500, 000 and $700, 000. That’s a potential swing in value of $200, 000. Often, the results of the other rules of thumb, measuring income streams such as SDE, EBIT, and EBITDA, will provide an even wider swing in potential values.
Now remember the two thumbs you were looking at earlier. The differences between your thumb and a potential buyer’s thumb can be quite significant, and generally speaking, no one knows what those differences will be until the two start comparing notes. It gets even more interesting if, instead of a potential buyer, the other thumb belongs to the Internal Revenue Service, or the out spouse in a divorce, or even a partner who wants to be bought out.
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When valuing a privately held business, or even a part ownership interest in a privately held business, there are many options to consider. Rules of thumb are very useful. They can provide a range of potential values. But when it gets right down to it, most of the time a more specific, and supportable number is needed.
If you have any questions, or you would like to learn how to measure the value of your clients’ businesses and pursue your Business Certified Appraiser (BCA) certification, please contact me at shyde@intlBCA.com. The International Society of Business Appraisers (ISBA) can teach you what you need to know to get started.
About the Author: Shawn Hyde, CBA, CVA, CMEA, has over 20 years of valuation and appraisal experience in numerous industries. He currently serves as the executive director of the International Society of Business Appraisers (ISBA), www.intlBCA.com. He is a Certified Business Appraiser, Certified Valuation Analyst and a Certified Machinery & Equipment Appraiser. He has written and taught courses for the Institute of Business Appraisers (IBA), the National Association of Certified Valuators and Analysts (NACVA), and the International Society of Business Appraisers (ISBA). He has served on the IBA’s Education Board and the IBA’s Board of Governors, and he is a past Editor in Chief of the IBA’s professional journal, “Business Appraisal Practice.”When it comes time to buy or sell a business, it’s important to set your personal feelings aside in order to do an accurate business valuation and establish a realistic and competitive selling price. You’ll need to objectively analyze the business, study the current market, and consider employing the expertise of a professional business appraiser.
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There are three common, acceptable business valuation methods. One may be more suitable than another, depending on the type of business being valued, including its industry, size, and circumstances of sale.
An income business valuation approach is a type of valuation based on projected future cash flow or earnings. It is recommended for businesses that have a large potential for growth. Entrepreneurs looking to purchase a business are doing so to make money. So, the largest factor a potential buyer will consider is the amount of money they stand to make in the future. There are two variants of this approach, capitalization of earnings and discounted cash flow (DCF).
With the capitalization of earnings method, the historical cash flow of a company is divided by its capitalization rate. A capitalization rate is expressed as a percentage and represents the rate of return on the capital including equity components and debt. This method helps to identify risks and quantify the potential return on investment. By using the net present value of cash flows from existing agreements or expected profits generated through ordinary course of business and adjusting for risk, this calculation is especially useful for valuing service-oriented businesses.
Rule Of Thumb Of Business Valuation
The discounted cash flow method takes the company’s projected cash flow and then discounts that amount for risk using the weighted average cost of capital. This projection is usually calculated for one year and then assumes perpetual and constant growth. Because of that assumption, this method of valuation is best used when an analyst is confident about the assumptions being made.
An asset-based business valuation focuses on the book value of a business and deducts liabilities. It is often used in conjunction with other methods of valuation and may be required as part of the due diligence process for private companies. Be sure to include not just the machinery and furniture of your business but also intangible assets such as patents, trade secrets, and trademarks. Measuring intangible resources is complicated because it requires accuracy, attention to detail, and experience.
A market-based business valuation is one of the simpler business valuation methods. By comparing your business to similar ones that have been sold recently, you can determine the value of your business. You will want to find companies with similar financials within your sector and then calculate the average of trading multiples (how the company operates). The multiples frequently used in this approach are return on equity, price to earnings, enterprise value (EBITDA), price to book value, and return on assets.
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Now that you have a sense of the different ways in which you can value your business, let’s discuss the rules of thumb. These tips will help you calculate the best price before putting your business up for sale.
The first rule of thumb for business valuation is preparing the company’s financial statements. The owner should gather the financial records for the past three years including: an income statement, a cash flow statement and a balance sheet. If the business hasn't been operating for three years, consider using a projection model.
Next, work with an accountant to transform the income statement into a seller’s discretionary earnings (SDE) statement, which considers non-recurring purchases and discretionary expenses to more accurately reflect the value of your business. SDE gives you a better idea of the true profit of your business because it includes expenses that aren’t required to run the business. These expenses include your salary (and the salary of any additional owners), travel that’s not essential to the business, relatives that have non-essential positions, charitable donations, leisure activities, and one-time expenses like settling a lawsuit.
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The second rule of thumb for business valuation is to establish the asset value of the business. First, estimate the value of the company’s tangible assets by taking inventory of all the physical aspects of the business such as fixtures, equipment and inventory. Real estate, cash on hand, and accounts receivable are also included.
Next, estimate the value of the company’s intangible assets, including intellectual property, contracts, partnerships, brand recognition, and more. Assigning value to intangible assets can be tricky and it may be best to consult with a business broker or professional appraiser.
While asset valuation gives you a clearer picture of the business’s current value, it fails to clearly reflect the value of the company’s earning potential. Since buyers are primarily interested in their investment’s future earnings, it’s a good idea to quantify an estimate of the company’s earning potential through price multiples.
Rule Of Thumb
Another valuation rule of thumb is using price multiples, which base the value of the business on a multiple of its potential earnings. Price multiples provide buyers with a tool to estimate their return on investment. They are a quick way to arrive at a general estimate of the business’s sale price.
Once you’ve established the asset valuation of the business, the next step is to determine the multiple that applies to the geographical region and type of industry. These numbers combine to form an equation that results in a fair estimate of the business’s sale price.
For example, nationally the average business sells for around 0.6 times its annual revenue. Once you’ve determined the annual revenue and found the correct multiplier, it becomes a simple matter of plugging the numbers in and then doing the math. The trick is to find the right multiplier for the business, since they can
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