Business Worth – The Trouble With Rules of Thumb

What is your business worth? There are many reasons you may wish to know the value of your business, such as preparing it for sale, tax and estate planning, seeking financing, or even divorce. Business owners often use rules of thumb to gauge their businesses’ values. But while these “cocktail napkin” estimates can give you a general idea of what your business is worth to help begin the planning process, they are no substitute for a thorough analysis by a valuation professional.

The Trouble With Rules of Thumb

Rules of thumb are easy-to-calculate valuation formulas that are typically tied to some multiple of earnings before interest, taxes, depreciation and amortization (EBITDA) or some other measure of earnings, revenues or cash flows. They are often derived from data about actual businesses sold in your industry, which provides an air of legitimacy.

 

The problem is that rules of thumb are usually based on industry averages. Most businesses, however, do not possess characteristics that are identical to the hypothetical average business, so applying a rule of thumb can lead to inaccurate results. For example:

 

Company A and Company B each have EBITDA of $2 million per year. According to a popular valuation rule of thumb in their industry, each company is worth five times EBITDA, or $10 million. The two companies are similar in many ways, but a closer look reveals that Company A relies on a single customer for more than 80% of its sales. Company B has a much more diverse customer base, with no single customer accounting for more than 10% of its sales. A prospective buyer that performs due diligence would view Company A as a substantially higher risk investment and adjust its valuation downward to reflect the additional risk.

Professional Valuation - There Is No Substitute

The example above is oversimplified but illustrates how rote application of rules of thumb can distort a company’s value. In practice, each business possesses numerous unique characteristics that drive its value and may not be captured by a rule of thumb estimate. Rules of thumb provide a handy way to get a rough idea of your business’s value or to serve as a “sanity check” against more sophisticated valuation methods, but only a professional valuation can provide the accurate information you need to achieve your goals and maximize your investment.

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