Rule of Thumb Business Valuation: What You Need To Know

As a commercial real estate advisor who often gets asked how to value a business for sale, I’m regularly consulted by small business owners wondering – what’s my company worth? It’s a fair question for entrepreneurs considering their future exit plans. Getting a business valuation can help set realistic expectations when the time comes to hang up the “for sale” sign.

While tempting to use a back-of-the-napkin rule of thumb, business owners should understand the limitations of this approach before making major decisions based on an overly simple valuation metric.

In this article, we’ll break down a few common rules of thumb for business valuation, when they may be useful, and why it pays to invest in a professional appraisal.

Key Takeaways

• Rules of thumb can provide a rough ballpark valuation range for small businesses but have limitations in accuracy.
• Common rules of thumb focus on multiples of revenue, earnings (EBITDA), or discretionary earnings.
• More rigorous valuation methods used by professionals evaluate assets, growth potential, competition, and other value factors.

How to Value a Business? What is It?

So, how do you value a business? What exactly is a business valuation? Well, it’s basically figuring out how much a company is worth in economic terms.

Some folks also call it a company valuation. When you’re doing a valuation, you’ve got to take a good, hard look at every nook and cranny of the business to determine its overall value, as well as the value of its different departments or units.

Now, there are plenty of reasons why someone might need a company valuation. Maybe they’re looking to sell the business and want to know what price to ask for. Or perhaps partners need to establish their ownership stakes.

Valuations can also come in handy for tax purposes or even during divorce proceedings when a business is involved.

To get an objective estimate of the company’s worth, owners often bring in professional business evaluators who know their stuff.

Common Rules of Thumb for Business Valuation

Before relying on any rule of thumb, remember – no two businesses are alike. Value depends on profit margins, growth, assets, liabilities, and market conditions. Rules of thumb short-circuit the analysis of these key value drivers.

With that huge caveat, let’s look at some popular shortcuts business brokers and owners use to ballpark value:

The EBITDA Multiple Rule

A common rule of thumb is assigning a business value based on a multiple of its annual EBITDA (earnings before interest, taxes, depreciation, and amortization). The specific multiple used often ranges from 2 to 6 times EBITDA depending on the size, industry, profit margins, and growth prospects.

For example, a retail store doing $100,000 in annual EBITDA could be valued roughly at $200,000 to $600,000 based on a 2X – 6X EBITDA rule of thumb.

The Discretionary Earnings Approach

Another shorthand for valuation looks at the owner’s discretionary earnings – their salary plus any additional profits they take home. This is multiplied by a factor ranging from 1 to 4.

If the owner pays themself a $150,000 salary, and the business clears another $100,000 in profit annually, their discretionary earnings are $250,000. Applying a conservative 2X multiple gives us an estimated business value of $500,000.

The Revenue Multiple Method

This rule attaches a value to several types of businesses based on their annual revenue or sales. The revenue multiple used often falls between 0.5 to 5 times yearly revenue depending on the industry.

For a company doing $2 million in gross annual sales, that could equate to a business valuation between $1 million (0.5X multiplier) up to $10 million (5X yearly sales).

The Problem With the Rules of Thumb Valuation Approach

Hopefully, the wide ranges in the examples above make it clear – rules of thumb leave much to be desired when it comes to nailing down business value. Relying solely on a shorthand revenue or EBITDA multiple can result in overpaying or leaving money on the table.

Here are a few reasons why rules of thumb fail to accurately capture value:

• Industry variation – Valuation multiples differ greatly based on sector, growth, and margins.

Increased focus on EBITDA by companies and investors has prompted criticism that it overstates profitability. The U.S. Securities and Exchange Commission (SEC) requires listed companies reporting EBITDA figures to show how they were derived from net income, and it bars them from reporting EBITDA on a per-share basis

• Ignores wealth of factors – Assets, liabilities, barriers to entry, and sustainability of income all matter.
• Can misguide negotiations – Emotions aside, smart negotiators argue based on supportable facts and figures.
• Not suitable for financing – Banks scoff at informal rules of thumb. They require substantiated valuations.

So when does it make sense to have a starting number based on a shortcut valuation method?

Appropriate Uses for Rule of Thumb Business Valuations

What is the rule of thumb for valuing a business?

Having highlighted their flaws, I don’t want to completely discredit the merits of valuation rules of thumb.

Here are some appropriate uses:

Very Early Planning Stages

When initially assessing selling scenarios or weighing succession planning options 5+ years out, rules of thumb can gauge feasibility. If an owner expects a $20 million valuation based on industry rumors, running some quick calculations using EBITDA or discretionary earnings may encourage more reasonable expectations.

Reality Check on Expectations

Every small business owner thinks their company is “special” when contemplating its value. Applying a rule of thumb multiples to earnings strips away emotive elements and introduces an impartial perspective. If the valuation exceeds expectations, terrific. If not, better to realign assumptions now than when you’ve already listed your business.

Listing Price Range for Business Brokers

When helping a business owner sell companies below $500k in value, some business brokers do anchor asking prices based on discretionary earnings multiples. But it’s still marketed as an estimated range subject to the buyers’ formal due diligence.

Common Valuation Mistakes I’ve Seen

In my years as a commercial real estate advisor, I’ve seen my fair share of valuation missteps. These errors can cost business owners dearly, whether they’re looking to sell, refinance, or make informed decisions about their property investments.

One of the most frequent issues I encounter is a misunderstanding of capitalization rates. I remember a retail strip owner who was convinced his property was worth millions more than the market value. He had confused cap rates with return on investment, a common but costly mistake that can lead to overvaluation and disappointed owners.

Location trends are another critical factor that’s often overlooked. I once worked with a client who nearly undersold a property in an up-and-coming neighborhood. They hadn’t recognized the emerging changes in the area that were set to boost property values significantly in the coming years.

Overly optimistic rental income projections are a trap I’ve seen many fall into. It’s tempting to include anticipated rent increases in valuations, but without solid market justification, this can inflate a property’s perceived value unrealistically.

Maintenance costs are frequently neglected in valuations, too. I recall an office building owner who forgot to factor in significant upcoming repairs. This oversight led to an unrealistic asking price that scared away potential buyers.

Lastly, the misapplication of comparables is a common pitfall.

It’s not uncommon for owners to cherry-pick high-value comps without considering crucial differences in location, condition, or lease terms. This can skew valuations and create unrealistic expectations.

These mistakes underscore why professional valuation isn’t just about arriving at a number. It’s about providing a strategic tool for informed decision-making in the complex world of commercial real estate. By avoiding these common errors, you can ensure you’re working with accurate, realistic valuations that truly reflect your property’s worth in the current market.

Final Takeaways on Business Valuation

• Don’t rely solely on the multiplicative valuation rule of thumb – consult real valuation pros!
• Factor profit history, stability, assets & liabilities, growth runway.
• Get appraisals annually to track the value of the business. Make changes to drive higher valuations! For more tips, check out our Guide: Increase Your Business Value Before Selling.

FAQs

Conclusion

I know valuing your business seems complicated and overwhelming. As an entrepreneur, you poured your heart and soul into building this company. It’s so much more than just a line item on a spreadsheet.

My role is to appreciate that personal connection while still providing an accurate,logic-based assessment to position you for future success, whether expanding operations or planning an exit. I’d be honored to have a thoughtful consultation focused on what matters most – your vision.

My goal isn’t quick rules of thumb but rather an understanding of your goals so I can offer custom strategic advice. Let’s have an open, judgment-free dialogue on how we can best serve your business needs moving forward.