What is my business worth?
It’s a question nearly every business owner asks in their business journey whether they are looking to sell, obtain financing, restructure, or prepare for succession planning. While researching methods to accurately value their business, many owners come across business valuation rules of thumb. While it might be tempting to use a rule of thumb because they seem quick, easy to understand, and inexpensive, most often than not, they produce inaccurate results that could muddy the picture and send the business owner down the wrong path.
Because rules of thumb business valuation methods ignore the traits that make your business unique, they often result in a significant over- or under- estimation of market value. These inaccurate valuations lead to poor, costly business decisions.
Keep reading to learn about business valuation rules of thumb, why they are problematic, and what valuation methods to use instead.
What are Valuation Rules of Thumb?
Business valuation rules of thumb apply a general industry multiple to one of your company’s financial metrics. These generic formulas are passed along by word of mouth and are often based on outdated historical transaction data. At best, rules of thumb provide an industry average, but in the real world, there’s rarely such a thing as an “average” business.
Businesses aren’t static; they evolve with market conditions, technology advancements, and regulatory changes. Rules of thumb don’t keep up with these market shifts.
Another issue is how much deal values vary. Even within the same industry, acquisition multiples can be very different from one transaction to the next. Using an average or median multiple may be convenient, but actual transaction data shows that deal multiples vary greatly.
Rules of thumb fail to tell you where your company lies within this wide range. For this reason, rules of thumb are a dangerous approach to company valuation, providing a false sense of accuracy. The only way to determine the true value of a company is by utilizing valuation methods that incorporate academically validated methods with industry-specific valuation factors.
Rules of Thumb Fail to Consider a Business’s Unique Characteristics
A reliable, valuation professional includes a range of financial factors such as profit margins, cash flow, debt levels, and rates of growth. There are also nonfinancial factors unique to a business that impact a business’ value. These factors include:
- Strength of customer base and relationships
- Product or service diversification
- Brand value
- Customer/client concentration
- Intellectual property
- Depth of the management team
- Length of operating history
- Volatility of earnings
- Recurring revenue
- Market position
Failing to capture these factors in a valuation leads to inaccurate results that don’t reflect a company’s unique strengths and weaknesses.
Example of Rule of Thumb Limitations
Let’s say Company A and Company B each have earnings before interest, taxes, depreciation and amortization (“EBITDA”) of $1.5 million during the most recent year. According to a widely used valuation rule of thumb in their industry, each company is worth 3.0x times EBITDA, or $4.5 million. While the two companies are similar in terms of EBITDA, let’s assume there are some critical differences:
| Company Attribute | Explanation of Differences |
| Client Concentration | Company A derives 75% of its revenue from three clients, while none of Company B’s clients represent more than 10% of its revenue. |
| EBITDA Growth | Company A’s EBITDA over the past three years is down 10% overall and has been volatile, while Company B’s EBITDA has increased steadily over the past three years at an average annual rate of 15%. |
| Tenure of Management Team | Aside from the owner, who started the company and holds many of the key relationships, Company A’s management team is relatively inexperienced, with an average tenure with the company and industry of three years. Company B has a strong and deep management team with an average tenure with the company of 20 years. |
| Efficiency of Technology and Processes | Company A is using outdated technology and processes. Company B has recently updated and streamlined many of its core internal processes and technology, which has led to a 20% increase in its EBITDA margin. |
When comparing Company A’s attributes to Company B’s, it seems clear that Company B is worth more, perhaps significantly more, even though the rule of thumb would value them equally.
Consequences of an Unreliable Business Value
When a business valuation is inaccurate, it leads to bad decisions and costly financial mistakes. No matter the purpose of the valuation, a business valuation that doesn’t truly reflect what makes your business unique causes problems down the road. For example, an incorrect valuation can mean paying far too much—or receiving far too little—during transactions involving majority or minority shareholders, such as selling the business, buying out a shareholder, or allowing an employee to buy in.
In some industries, rules of thumb are widely accessible, and it may make sense to use them as a supporting reference. They can help back up and analyze a more detailed, income- and/or market-based professional valuation. Any differences between the rule-of-thumb value and the professional valuation can then be reviewed and discussed.
Ultimately, while rules of thumb may be able to provide a single, rough estimate of business value, they should never be used as the sole valuation method. An approach that considers all the unique characteristics of your business, both positive and negative, as well as current market conditions, is essential for an accurate and meaningful valuation.
Anders valuation services help business owners understand what a business is really worth, so future planning and decision making is based on accurate information. To learn more about our services, request a meeting below.