The rule of thumb has a long history in the business world especially when it comes to valuing business interests in the community. In order to avoid formal valuation report costs, shareholders utilize benchmarks of the industry and rules of thumb to estimate the ballpark values of their interests. This approach acts according to different scenarios where the rule of thumb may be more or less effective.
This article will cover all about the rule of thumb business valuation approaches, when to use them, and their pros and cons.
Rules of thumb and business valuation
Valuation techniques can materially undervalue or overvalue business interests. It enables shareholders to estimate the rough value of their business quickly and cost-effectively. However, in scenarios where you have to estimate a more precise and technical value like estate planning, litigation, and transactions—rules of thumb do not provide an accurate value.
What is a rule of thumb business valuation approach?
The rule of thumb is a business valuation method that is based on common sense and experience. It is a general principle that is regarded as approximately accurate but not meant to be scientifically correct. For estimating the value of a business, the process involves applying a multiple to an economic benefit of a specific industry. Metrics such as discretionary cash flow or business revenue are used.
A company’s goodwill might be worth 2x more than the discretionary cash flow, or the accounting practice’s value might be worth 1 to 1.35x the annual revenue + work-in-progress (inventory). The rule of thumb traditionally originated from the combination of observations, real-world market transactions, hearsay, and experience.
When to use the rules of thumb for a business valuation?
This approach usually values a company depending on multiples from the specific industry such as cash flows, revenues, EBITDA, and others. Even though this is a valid method, you cannot use only this approach while valuing a business. The reason for this is that the rule of thumb only gives an estimated valuation that is specific to the industry. Different markets will have several different variations in multiples from the rule of thumb.
Many other factors affect the valuation of a business. If two businesses are in the same industry, it is not necessary that you can compare them with each other as there can be differences in the business practices, customer base, cost structures, etc. A business valuation through the rule of thumb approach is generally developed over a long time. But, companies and industries keep evolving and growing and applying old value factors can give you an incorrect estimate.
That said, business owners can still benefit from a rule of thumb as it can provide insights on a ballpark estimate for the value of a company. It can also suggest special purchasers, those who willingly pay a higher price for a company, by benefitting from the perceived synergies of purchasers.
For many business owners, getting a formal valuation is worth the investment. Some reasons why include needing a more detailed picture of your company’s value, submitting taxes, outlining employee stock option plans, or presenting to investors or creditors.
Rules of thumb in business valuation
The general rules of thumb are a good measure for certain industries, and where your company may stand compared to other industry peers. So seeing how the metrics in key industries stack up against each other may give you insight into whether your company is performing well or not.
Many companies come from a variety of industries. While companies are all different, getting a valuation is the same process regardless of the industry. To explain further, let’s take a look at this list of the most profitable industries (according to a recent writeup from Yahoo Finance).
- Software (system and application)
- Computer peripherals
- Drugs and Pharmaceuticals
- Oil and Gas
- Household products
- Computer Services
- Healthcare Support Services
- Life Insurance
- Semiconductor Industry
In order to conduct the valuation for companies in these industries, there are several calculations that valuation analysts use. The following formulas are used to calculate the various aspects of the business valuation:
Where Net Sales = Annual Gross Sales, net of returns and discounts allowed, if any.
The sales multiplier is the most used valuation metric, as it takes your total sales and compares them to other companies and their sales multiples. The majority of small and medium-sized companies used this metric for their valuation.
Where EBITDA = Operating Profit + Depreciation & Amortization
EBITDA means Earnings Before Interest, Taxes, Depreciation, and Amortization. This is commonly used for finding the value of medium to large businesses. Investors are able to compare your business to others in the same industry by taking away the expenses that skew a fair comparison.
Where SDE = Operating Profit + Depreciation + Amortization + Owner’s Compensation
SDE stands for seller’s discretionary earnings. This is the most common multiple to value small businesses. By using this, someone who is looking to acquire your business lets them know how much they would earn if they worked in the company.
Gross Profit Multiple
Where Gross Profit = Net Sales – Cost of Goods Sold
Obtaining the gross profit can work best as a valuation method for companies that are losing money, but their gross profit serves as a good indicator for their total value.
Rule of thumb table
Given below is a table that describes the sales multiple, EBITDA multiple, SDE multiple, and profit multiple of various businesses. Have a look at it to understand more about the figures.
|Sales Multiple||EBITDA Multiple||SDE Multiple||Profit Multiple|
|1. Software (system and application)||0.7||6||3.5||3|
|2. Computer peripherals||2||5.8||1.2||3.9|
|3. Drugs and Pharmaceuticals||3.3||10||9.7||5.1|
|4. Oil and Gas||0.7||3||3.4||4|
|5. Household products||0.6||4.1||2.7||1.1|
|6. Computer Services (maintain and repair )||0.7||2||2.8||0.9|
|7. Healthcare Support Services||0.9||6.5||2.9||0.8|
|8. Life Insurance||1.8||5||5||1.9|
|9. Semiconductor Industry||2||5.8||1.2||4|
Pros and cons of the rule of thumb valuation approach
The rule of thumb valuation approach has several pros, but also cons. It’s important to know why this approach can be helpful but also why it won’t work for certain situations.
- The approach is straightforward, simple, and fast to apply
- You can save money and time to determine the value
- There are times that the rules of thumb are noted in buy-sell agreements to assist concerned parties in seeing the value they would receive in the transferral of equity
- The approach can have hidden assumptions concerning the risks and profitability of a company, which can lead to an incorrect valuation and a drop in price
- It does not reflect the essential items in the balance sheet (such as debt levels, real estate, non-operating assets, or cash on hand)
- Due to one-time shortfalls, the rule of thumb can drive wrong conclusions and estimations.
Examples of rule of thumb valuation
Let us take an example to understand the rule of thumb better. One rule in this approach is that insurance agencies tend to sell for 1 to 1.5x their net commission revenue. This generates an MVIC (market value of invested capital) basis. Here are two scenarios in which the rule of thumb can play out:
An insurance agency has a revenue of $2m. It has $600,000 in EBITDA. The valuation can be $2.4m MVIC. This falls within the spectrum of 1-1.5x of the net commission revenue rule of thumb.
The agency revenue is steady at $2m, but the earnings before interest, tax, depreciation, and amortization drop to $360,000. The value is close to $1.4m. This value is less than the rule of thumb guidelines and settled in the spectrum of $2m to $3m. This means that you would have overpaid for the company.
Get professional advice for valuation
Business shareholders have a unique tool to give a rough value of their business interests. This is an opportunity for them to estimate the ballpark value of the business fast and cost-efficiently. Shareholders can use the method in limited scenarios, be cautious, and not only rely on the rule of thumb valuation.
Keep in mind that it is vital to know and understand the limitations and inner workings of the valuation method. It is best that before you use the rule of thumb valuation as your only estimation method, you should consult a professional for advice.