Should Rules of Thumb Be Used to Value a Business?
I frequently receive requests to quickly value a business by applying a “rule of thumb”, that is, application of a simple formula to the gross or net income of a business to determine its value. The value of a business is based on two factors: cash flow and risk. Using a rule of thumb to value a business considers neither.
Rules of thumb are old wives’ tales of business valuation; no one knows where they come from or the basis upon which they were derived.
How rules of thumb get it wrong
As a simple example, consider two hypothetical businesses in the same industry (Company A and Company B). Each has $2 million of sales and $400,000 net income. Using a rule of thumb would result in both businesses having the same value. But what if all of Company A’s sales came from a single customer, and Company B’s sales consisted of $100,000 each to twenty customers. Which company is more valuable? Company A clearly has more risk because the loss of a single customer would put it out of business. However, this factor, and many similar factors, are never considered by rules of thumb.
In determining what they will pay for a business, investors consider projected cash flow and risk that projected cash flow will not be realized. A fair market value buyer pays for cash flow; the greater the cash flow the more the buyer will pay. Cash flow includes funds available for distribution during the period of ownership, as well as the amount received upon the sale of the business. The cash flow is discounted at a rate based on risk; the greater the risk the higher the discount rate and the lower the business value.
Risks to consider
Risks common to many businesses include customer and/or supplier concentration, competition, lack of management depth, and product obsolescence. This list is not all inclusive as most businesses are unique and may face other risks not mentioned.
We’ve got your back
Estimating the value of a business requires thorough analysis of the business, the industry, the marketplace, and the economy. If you want to know the value of a business, don’t use a rule of thumb; engage a business valuation professional. You will be glad you did.