Sometimes business owners will ask, can I use a rule of thumb to value my business? It’s a good question.
You certainly can, but you should understand the pros and cons of rules of thumb before you make your decision.
What are rules of thumb?
A rule of thumb is a broadly accurate guide or principle. It’s based on experience or practice rather than theory.
In the valuation industry, these are short statements like “all businesses in x industry sell for 1 times its revenue.” For example, all insurance agencies sell for 1 to 1.5 times their cash flow.
Rules of thumb are simple, straightforward, and quick to apply. Some people believe that rules of thumb can help them avoid lengthy or costly processes to determine what could be the same answer.
Sometimes, rules of thumb are written into buy-sell agreements to help parties see what value they would get in a transfer of equity at any point in time. Clarity, simplicity, and low cost are great pros, but there are some downsides to consider.
Rules of thumb may be accurate if your company falls within industry norms; however, rules of thumb have hidden assumptions about profitability and risk.
If your company doesn’t fall within those assumptions, the rule won’t work for you. And, rules of thumb usually cover large ranges. You’ll see how this can contribute to an inaccurate valuation in the lower profit case below.
Also, rules of thumb don’t consider important balance sheet items like cash on hand, debt levels, or nonoperating assets like cars or real estate.
These items can significantly alter the amount of equity in one company compared to another – even if their operating performance and profitability are exactly the same.
Finally, rules of thumb can lead to distorted conclusions due to one-time shortfalls or windfalls. Their static nature removes consideration of the material impact that some factors could have on value.
Let’s walk through an example. One rule of thumb is that insurance agencies sell for 1 to 1.5 times net commission revenue. This yields a market value of invested capital basis (MVIC).
Here are two ways this rule of thumb could play out for an insurance agency.
1. Base case
The insurance agency has $1 million in revenue. They have $300,00 in earnings before interest, taxes, depreciation, and amortization (EBITDA).
With a multitude of EBITDA, their valuation could be $1.2 million (MVIC). This falls well within the 1 to 1.5 times net commission revenue rule of thumb.
2. Lower profit case
If the insurance agency revenue stays steady at $1 million, but EBITDA drops to $180,000, the valuation is closer to $700,000.
This is less than the rule of thumb guidelines. If you engaged in this transaction based on the rule of thumb, and paid in the range of $1 to 1.5 million, you’d overpay for this company.
Conclusion? Buyer beware.
It might be tempting to use a rule of thumb when valuing your business. The valuation could fall within the rule of thumb range, but wouldn’t you rather have an accurate assessment?
Of course you would. Make sure to ask for a comprehensive business valuation instead.
Have questions about business valuations? Let’s talk!