What are the convenient rules of thumb for business valuation?
Certain situations require a formal, written, fully documented business valuation. However, what we’re talking about here is not a formal appraisal but rather using widely accepted rules of thumb to estimate the value of a business.
All of the guidelines we’ll quote are based on the opinions of industry experts and averages derived from hundreds of completed transactions reported to national databases.
The Two Methods
Two commonly used rules of thumb for quickly approximating the value of a business are: (1) applying a multiple to the discretionary earnings of the business and (2) applying a percentage to the annual gross revenue of the business.
The most accurate of the two guidelines seeks to approximate the value of a business by applying a multiple to the company’s discretionary earnings. What are discretionary earnings? Discretionary earnings are NOT the profit or loss that you show Uncle Sam on your tax return. To put it delicately, almost all business owners run some expenses through the business that are — a’hem — not absolutely necessary to the operation of the business.
What Are Discretionary Earnings?
Discretionary earnings are the total cash that the business generates in a year that is available to the owner after deductions for only the necessary operating expenses. Another way to define discretionary earnings is that it is the “total owner’s benefit” derived from owning the business, regardless of how the owner takes the money out of the business. Here’s an article explaining the subject in more detail.
The Multiple of Discretionary Earnings Method
Almost all privately held businesses will appraise for somewhere between one to six times discretionary earnings. Exactly where in this range a specific business falls depends on the type of business.
From the database of completed transactions, we know that an air-conditioning/heating contractor, for example, is valued at approximately 2 to 3.5 times discretionary earnings. A retail gift shop is worth about 2.5 to 3.5 times discretionary earnings. Home health care is 2 to 4 times; dry cleaners are 2.5 to 3.5. Wholesale distributors, in general, are valued at between 2.75 to 3.75 times discretionary earnings. Where within these ranges by category a particular business falls depends on many factors considered by valuation experts.
The Percentage of Revenue Method
A less accurate rule of thumb method of estimating the value of a business is to apply a percentage to the company’s annual gross revenue. For example, a full-service restaurant will be worth about 30 to 40 percent of annual gross revenue if — big “if” — it’s earning the average bottom line profit for its peer group.
As other examples, auto service shops will be valued at 30 to 40 percent of annual gross revenue, long-haul trucking companies at approximately 40 percent, and dry cleaners at 60 to 70 percent.
But again, remember that these values derived by using a percentage of annual revenue must be supported by bottom-line earnings.
These Items Should be Added to the Guideline Results
None of these appraisal guidelines include the value of any real estate or inventory on hand. If the business owns real estate, the value of the realty should be added to the guideline result. And inventory, at cost, should also be added to obtain the total estimated value of the business.
However, you as the owner, seller or buyer of the business are the final arbiter of what the business is worth to you. Remember, these guidelines are only averages. And the guidelines certainly don’t take into account any special considerations or any future plans that an owner might have for the business. What a particular business might be worth to you may be more or less than it’s worth to the next person who looks at it.
One final observation: Interestingly, there is little geographic deviation in the value of businesses. A gift shop in Alabama with similar financial performance is worth about the same as one in California.
Here are additional articles that might be of interest: Small Business Valuation Multiples Explained, How to Analyze a Business You’re Considering Buying, How to Write an Offer to Buy a Business, and How to Handle the Due Diligence Investigation When Buying a Business.
If you have questions about business valuation, please contact me at (251) 990-5934 or Will@WilliamBruce.org. In addition to estimates of value using rule-of-thumb guidelines, we also produce written, fully documented business appraisals for banks, business buyers and sellers, minority / majority partners and others using at least two methodologies to come to a conclusion of market value.
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William Bruce is a business broker, an Accredited Business Intermediary and a business valuation specialist. He currently serves as president of the American Business Brokers Association. His practice includes consultations nationally on matters involving business valuations and transfers. He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org.
(C) Copyright William Bruce. All rights reserved.