What is the Rule of Thumb for Valuing a Business
If you need a quick estimate of a business’s value, there are various rules of thumb that can provide a rough calculation. These simple formulas measure a business’s value in relation to specific financial performance metrics and recent market trends. Understanding a business’s market value enables informed decision-making, whether you are buying, expanding, or selling a business. However, when using a rule of thumb for valuing a business, it is important to note that there are many key factors that may be overlooked.
In this article, we’re discussing the most common rules of thumb for valuing a business. Keep in mind, these methods often provide vague results and should not replace a full business valuation. If you need a credible and accurate estimate of your company’s worth, it is best to connect with a certified business appraiser.
Peak Business Valuation is a reputable business appraisal firm that helps thousands of small business owners understand their company’s worth. We are here to provide you with a professional small business valuation! Additionally, we can answer any questions you may have about rules of thumb or the valuation process. Get started today by scheduling your free consultation below!
Understanding Rule of Thumb Business Valuations
A rule of thumb business valuation uses industry-standard valuation multiples to estimate a business’s worth. Multiples are financial ratios that reflect current market trends for companies in a specific industry. These metrics are typically derived from financial performance indicators such as:
- Seller’s Discretionary Earnings (SDE)
- Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
- Revenue
Each industry tends to have its own set of market multiples. For instance, a dental practice could sell for 1 to 2 times SDE, while a retail business might sell for 2.5 to 3.2 times SDE. These rules are based on trends from past transactions and can be a useful reference point. However, rule of thumb business valuations are best for informal scenarios that do not require precise estimates.
Common Rule of Thumb Valuation Methods
There are several common rule of thumb valuation methods. The best rule of thumb for valuing a business depends on the nature of the company, industry norms, and asset composition. At Peak Business Valuation, our business appraisers often refer to SDE, EBITDA, and revenue when valuing a business. Below, we discuss each metric and provide an average range of multiples for small businesses.
For more information on market multiples, check out Valuation Multiples for a Small Business.
SDE Multiples
Seller’s Discretionary Earnings (SDE) is often used when valuing small, owner-operated businesses. This metric reflects the total financial benefit available to the owner of the company. To calculate SDE, certain expenses are added back to the business’s net income. Some common add-backs include the owner’s salary and non-recurring or one-time expenses.
Rule of Thumb: Business Value = SDE x Multiple
Multiple Range: Small businesses often transact within a multiple range of 1.50x to 3.00x SDE.
To learn more about SDE, read Understanding Seller’s Discretionary Earnings.
EBITDA Multiples
Next, EBITDA refers to Earnings Before Interest, Taxes, Depreciation, and Amortization. This metric is a common valuation basis for larger businesses or those with multiple locations. It measures earnings generated solely from the business’s operations. As such, EBITDA is useful for assessing a business’s operational efficiency and profitability.
Rule of Thumb: Business Value = EBITDA x Multiple
Multiple Range: EBITDA multiples generally range from 3.00x to 5.00x, depending on size, industry, and financial performance.
Revenue Multiples
Revenue is the sum of a business’s total sales over the most recent 12-month period. This measurement can offer insight into a business’s size and market position. However, since revenue does not account for profitability, it is primarily used for industries with slim margins or when financial data is limited.
Rule of Thumb: Business Value = Revenue x Multiple
Multiple Range: Revenue multiples can vary significantly from 0.50x to 2.00x or more.
As a professional business appraiser, Peak Business Valuation may utilize a combination of the above multiples as part of a comprehensive business appraisal. We regularly work with individuals looking to buy, expand, or sell a business. If you need a reliable estimate of a business’s value, we are here to assist! Start by scheduling a free consultation below!
Risks of Using a Rule of Thumb for Valuing a Business
Although rules of thumb can be helpful for rough estimates, relying solely on these methods can lead to costly mistakes. Below are a few important risks of using a rule of thumb for valuing a business.
- Outdated Data: Multiples can shift over time with market conditions. Relying on outdated data can lead to a misleading valuation.
- Industry Generalizations: Even within the same sector, different businesses can vary widely in size, margins, and risk. As such, standard multiples are not a true reflection of every business.
- Neglecting Unique Factors: The value of a business is heavily influenced by factors like customer base, location, brand reputation, etc… These value drivers are not accounted for in rule of thumb formulas.
- Overlooking Future Growth: Rules of thumb do not consider a business’s future growth potential. This is a crucial factor that impacts the worth of a business.
If you are in need of an accurate and defensible business valuation, using a rule of thumb is a risky option. For the best results, it is essential to work with a certified valuation expert. These professionals take thorough measures to provide a tailored estimate. Peak Business Valuation is happy to answer any questions about the valuation process during a free consultation. Reach out today to get started!
Conclusion
Applying a rule of thumb for valuing a business is a helpful starting point if you need a quick, data-backed estimate. However, these simple methods are based on general data and do not account for the unique conditions of every business. To get an accurate estimate of a specific business’s worth, consider working with a professional business appraiser. These valuation experts conduct a variety of thorough analyses to ensure a comprehensive value estimate.
Peak Business Valuation is a trusted business appraiser that specializes in valuing small businesses across dozens of industries. Whether you are buying, expanding, selling, or seeking financing for a business, we can help you with an accurate valuation. In addition, we are here to address any questions you may have on rules of thumb. Click the button below to schedule your free consultation with Peak Business Valuation today!
For additional guidance, see Valuing a Small Business and How to Value a Small Business
