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April 30, 2024

Beware of Rules of Thumb for Your Business Valuation

When determining a business’s value, it may be tempting to turn to an industry valuation “rule of thumb” because it’s quick, easy to understand and inexpensive. Relying on an industry rule of thumb can lead to a significant over- or understated value, increasing the risk of poor and even costly decisions. Relying solely on a rule of thumb is one of the most common shortcuts untrained valuation practitioners use. In short, rules of thumb fail to reflect a business’s unique characteristics.

What are Valuation Rules of Thumb?

Rules of thumb in the context of business valuation, such as applying an industry “multiple” to a financial metric for your company are often based on general industry observations, formulas passed along by word of mouth over time and long-range, often outdated historical transactions.  At best, rules of thumb represent an average. In the real world, there’s rarely such a thing as “average.” It can provide a false sense of precision and be a dangerous approach to valuation.

A critical limitation lies in the rule of thumb’s lack of adaptability. Industries aren’t static; they evolve with market conditions, technological advancements and regulatory changes. Since rules of thumb are generally based on historical observations, they often fail to reflect recent industry or market shifts. Further, there’s typically no substantive or verifiable market support for a particular rule of thumb multiple.

Another challenge relates to the dispersion of acquisition multiples observed for actual industry transactions. For a given industry, observed multiples will lie across a wide range. A median or average multiple over some historical period is a convenient midpoint, but, in reality, multiples from transaction data illustrate that acquisition multiples within almost any industry are all over the map.

Determining where your company lies along the continuums above is of the utmost importance. It can only be determined by a valuation approach that incorporates academically validated methods with industry-specific valuation factors. As demonstrated by the wide ranges in multiples, the multiple for your business may vary wildly from the industry median or average.

Rules of Thumb Fail to Consider a Business’s Unique Characteristics

A range of financial factors for the subject business, such as profit margins, cash flow, debt levels and rates of growth, are essential parts of developing a reliable value for a given business that aren’t captured when using a rule of thumb.

In addition, nonfinancial characteristics unique to a business are critical factors to assess a business’ value but are not captured in a rule of thumb. These factors may include the following:

  • Strength of customer relationships
  • The degree of product or service diversification
  • Brand value
  • Customer concentration
  • Intellectual property
  • Depth of the management team
  • Length of operating history
  • Volatility of earnings
  • Recurring revenue
  • Market position

Failing to reflect these factors lead to 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:

  1. Company A derives 75% of its revenue from three clients, while none of Company B’s clients represent more than 10% of its revenues.
  2. 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%.
  3. 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.
  4. Company A is using outdated technology and processes. Company B has recently updated and streamlined many of its core internally 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

An inaccurate value for your business can lead to poor, costly decision-making and financial mistakes. Whether you’re planning for an internal or external transaction, seeking investment or planning for growth, using a business value that fails to capture your business’s unique attributes can have long-term consequences. For example, a value that is miscalculated can result in significant underpayment or overpayment in situations involving a majority or minority shareholder transaction, such as a sale of the business, shareholder buyout or employee buy-in​​.

In some industries where rules of thumb are widely established, it may be reasonable to consider the rule of thumb as a secondary approach. It can perhaps support a primary and more thorough income and/or market-based valuation approach. Differences between the primary valuation approach(es) and the rule of thumb may be considered and examined.

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 basis for determining the value of a company. An approach that considers all facets and unique characteristics of your business, both positive and negative, as well as current market conditions, is essential for an accurate and meaningful valuation.

Anders Forensic, Valuation and Litigation Services group helps business owners and those considering acquiring a business or business interest determine the business’ true value to ensure all future planning is based on accurate information. Learn more about our services, and the associated costs, by requesting a meeting below. 

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