Using Rules of Thumb in Valuing a Business
Rules of thumb may be easier, but considering factors such as cash flow and risk lead to a more accurate business valuation.
From time to time, I receive a call from someone who wants me to tell them the value of a business that they want to buy or sell. They provide a few items of information, such as last year’s sales or net income and expect that I will apply a multiple to quickly and easily come up with a value*.
What they are asking me to do is apply a rule of thumb.
Old Wives’ Tale
Rules of thumb are the old wives’ tale of business valuation. Even in the same industry, every business is unique. Application of an industry-based multiple (rule of thumb) relies on the incorrect assumption that all businesses within an industry are the same.
As an example, let’s consider two local hardware stores that are identical in every way. Each has $2 million in annual revenue which results in $250,000 of income. For the last ten years, each store has shown 2.5% annual growth. Using a rule of thumb to estimate the value of these stores would yield similar results, regardless of whether the multiple relates to gross or net income.
However, what the rule of thumb does not consider the fact that in three months, a Home Depot store is opening across the street from one of the stores. Is it likely that the rule of thumb is still valid and the stores are of equal value? Probably not!
Factors to Consider
Experts consider a number of factors in estimating the value of a business, the most important being future cash flow and risk. Of course, historical operating results are used to help project the future, but the blind application of a rule of thumb will almost never yield a correct result. Even if sales or net income can be projected, rules of thumb do not consider risks specific to the company being valued. Customer or supplier concentration and the effect of the local economy on the business are just a few of these risks.
What is Your Business Really Worth?
Your business is probably the most important and valuable asset that you own. When you need to know its value, do not short change yourself by using a rule of thumb. Have your business valued by an expert, who will use proper methods to come up with the correct value and help you understand how to increase value. You may be surprised to learn that your business can be worth even more than you think!
If you have questions about the value of your business, give me a call at 201-655-7411 or email GShanker@KRScpas.com.
*A valuation multiple is simply an expression of market value relative to a key statistic that is assumed to relate to that value. To be useful, that statistic – whether earnings, cash flow or some other measure – must bear a logical relationship to the market value observed; to be seen, in fact, as the driver of that market value. (UBS Valuation Multiples Primer)
