Summary
Rule of thumb business valuations can be misleading when valuing your most valuable asset, your company. A small investment in a certified valuation can have a great return.
Rule of Thumb Business Valuation Worth
As a business valuation expert, if I had a buck for every time a professional adviser or business owner asked me about a Rule of Thumb valuation (ROT) value for a particular business, I would be fishing right now (and you would not be reading this blog). The truth is that I have never received even a single dollar for that information. I hope that tells you the value of a ROT as a business appraisal method.
Most Business Valuation Rules of Thumb are based on a multiple of gross revenue, net sales, EBITDA or the Seller’s Discretionary Earnings and are a rough guide at best when valuing a company.
Determine the Value of your Company
A Rule of Thumb Valuation is a Very Rough Estimate
At best, a Rule of Thumb valuation is a rough estimate. While rough may appease a mild curiosity today, rough will equate to actual dollars in the future. Take a moment to think this through to its conclusion. There are only so many reasons why you need to know the value of a business. For example, it might be for sale, transfer to the next generation, buy/sell agreement, insurance, retirement, or tax planning.
Any decisions you make in these areas based on the value of your business hold significant real dollar value for you in the future. Other than “bragging rights,” you have only serious reasons you need to know, and even fractions off can be costly.
Know the true value in a business valuation, and please read the different methods to value a small business.
When the day comes, those dollars are real. You will find that your original estimate based on ROT is off by 100’s of thousands to millions of dollars. If you have ever made a mistake that cost $200,000 to $2,000,000 in your life before, you do not want to do it again. Moreover, if you never have before, why set yourself to do the unthinkable now? Knowing the rough estimate of a business based on ROT is precisely that, setting yourself up to make a costly mistake.
Why is ROT so “rough” when estimating business value?
The Multiple: Most rules of thumb provide a variety of possible calculations. Typically, they express as an amount you multiply (the multiple) by some measure of business performance (gross sales, gross profit, profit margins, or earnings). For example, a business in question could have a rule of thumb that states 3 to 5 times earnings. If an accurate earnings description is $500,000, the value could be too high or too low by $1,000,000! Alternatively, it might state three times earnings or 80 to 100% of revenue or a sales multiplier.
Similar Businesses, Different Valuations
How could two businesses in the same industry with the same annual sales revenue and different earnings be worth the same amount? One business could have a stronger balance sheet and more consistent cash flow than the other. Or it could have more valuable intellectual property, an executable and scalable business model or business plan, or a much higher market share. That is why we use 5-7 business valuation methods versus just one rule of thumb approach.
Using the right valuation methodology is critical to determining your correct value. That is why we use the discounted cash flow approach, market approach, and capitalization of earnings approach versus just a rule of thumb method.
Please see our guide on how to value a business and why a small investment in an enterprise valuation is critical to your long-term business success and understanding your company’s market value.
The Earnings: The earnings of the subject business must match the type of earnings used for the ROT multiple. This is not always obvious and can be complicated. What are the earnings for the multiple based on? Net Income, EBIT, EBITDA, Market Value of Invested Capital (MVIC), or Seller Discretionary Earnings?
For many closely held businesses, the difference between each of these types of income streams can vary widely. Applying the wrong income stream to the ROT multiple multiplies the amount of potential error in your value assumption. How your discretionary cash flow is computed is critical to the valuation process.
Please read our article on how to value a company for investors when you do your estate planning.
Discounted Cash Flow Valuation Method
Cash flow analysis or discounted cash flow is critical when knowing the value of your business today as a small business owner doing retirement planning. You need to understand your company’s total market capitalization. We can also include your business’s real estate if applicable in today’s interest rate environment. Common sense says your small business is worth more than its book value.
In conclusion, even if knowing the value of a small business is simply for “bragging rights,” I would personally be much more impressed if I knew the value of the business in question was generated by making the nominal investment in a professionally prepared valuation, rather than a valueless ROT multiple.
Links of Interest for a company valuation:
http://www.inc.com/magazine/20101101/how-much-is-your-company-worth.html
Business Appraisal FL|GA|HI can give you a fast and cost-effective business valuation to know what your business is worth. Our valuation can be used for an SBA, IRS, or court proceedings or to confirm the cash flows. Don’t hesitate to contact us today for a free sample business appraisal and a discussion of the valuation process we use to determine the value of a business.
Whether you own a liquor store, a staffing company, three auto repair shops, or a large manufacturing plant, you don’t have to spend much money for a certified company valuation versus a ballpark value.
