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Rules of Thumb Business Valuation Methods Explained
The rule of thumb has a long history in the business world, especially in valuing business interests in the community. To avoid formal valuation report costs, shareholders use industry benchmarks and rules of thumb to estimate the values of their interests. This approach varies in effectiveness based on different scenarios.
This article will cover rule of thumb business valuation approaches, when to use them, and their pros and cons.
Rules of Thumb and Business Valuation
Valuation techniques can undervalue or overvalue business interests. Shareholders can quickly and cost-effectively estimate the rough value of their business using the rule of thumb. However, for more precise and technical values required for estate planning, litigation, and transactions, rules of thumb are insufficient.
What is a Rule of Thumb Business Valuation Approach?
A rule of thumb is a business valuation method based on common sense and experience. It is approximately accurate but not scientifically correct. The process involves applying a multiple to an economic benefit of a specific industry, using metrics such as discretionary cash flow or business revenue.
For example, a company’s goodwill might be worth twice the discretionary cash flow, or an accounting practice might be valued at 1 to 1.35 times the annual revenue + work-in-progress (inventory). The rule of thumb originated from observations, real-world market transactions, hearsay, and experience.
When to Use Rules of Thumb for Business Valuation?
This approach values a company based on multiples from the specific industry, such as cash flows, revenues, EBITDA, and others. However, it cannot be the sole method for valuing a business. Different markets have variations in multiples from the rule of thumb.
Other factors such as business practices, customer base, and cost structures also affect the valuation of a business. Applying old value factors can lead to incorrect estimates as companies and industries evolve and grow over time.
That said, business owners can still benefit from a rule of thumb as it provides insights into the ballpark estimate for a company’s value. It can also suggest special purchasers who are willing to pay a higher price for a company by benefiting from perceived synergies.
For many business owners, getting a formal valuation is worth the investment. Some reasons include needing a more detailed picture of your company’s value, submitting taxes, outlining employee stock option plans, or presenting to investors or creditors.
Rules of Thumb in Business Valuation
General rules of thumb are a good measure for certain industries and can provide insight into how your company compares to industry peers. To further explain, let’s look at a list of the most profitable industries:
- Software (system and application)
- Computer peripherals
- Drugs and Pharmaceuticals
- Oil and Gas
- Household products
- Computer Services
- Healthcare Support Services
- Life Insurance
- Semiconductor Industry
- Information
Valuation analysts use various calculations to conduct valuations for companies in these industries.
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