Rule of Thumb Business Valuation - The Complete Guide

Using a rule of thumb business valuation can be quick, inexpensive, and easy to understand. But is it an excellent idea?

In this guide, we'll discuss what a business valuation rule of thumb is, some types you can use, and the disadvantages of using this valuation method. 

Because of the method's limitations, you would be better off working with M&A experts to help you leverage your business's unique nuances and value it accurately. 

At Exitwise, we help you find and collaborate with experienced industry-specific M&A professionals to help you with the entire exit process from valuation to post-closing transition. Reach out to our team today.

What is the Rule of Thumb Business Valuation Method?

The rule of thumb business valuation method is a business appraisal technique that applies a multiple to a given financial metric based on general industry experience or formulas passed down over time. 

The technique may also be based on common sense and is widely accepted as approximately correct but not necessarily correct from a scientific point of view.

As a business owner, you can use a rule of thumb for business valuation in the early stages of exit planning to gauge the feasibility of the method and the exit.

If you hope for a high-value exit based on the current industry trends, you can run some quick multiple-based calculations using discretionary earnings or EBITDA.

Tip: If the valuation doesn’t meet your expectations, you can address issues sooner. You'll have more luck resolving issues early than when you've already listed the business for sale.

Common Rules of Thumb for Business Valuation

Now that we know what valuing a business rule of thumb means, let's check out some common techniques you can apply:

1. EBITDA Multiple Rule

The EBITDA multiple method assigns your company value based on a multiple of its annual Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).

The multiple may also apply to the average EBITDA determined for a period, usually the last 3-5 years.

Since EBITDA is a financial performance metric, the EBITDA multiple rule is ideal for companies or businesses with over $1 million in annual revenues and are expected to grow rapidly.

The specific EBITDA multiple you use to value your business depends on the industry, business size, growth potential, and profit margins.

As with other multiple-based business valuations, the EBITDA multiple comes from a detailed market assessment of the multiples at which recent businesses were sold in the same industry.

Here's a quick example:

• Annual EBITDA for business XYZ = $1.5 million

• Recent businesses within this EBITDA sold at an average 17.16x multiple

Estimate value of XYZ = Annual EBITDA x Multiple = $1.5 million x 17.16 = $25,740,000.

2. Discretionary Earnings Approach

The discretionary earnings multiple method considers the seller's annual discretionary earnings (SDE). The SDE refers to the salary and any other financial benefits or profits you take home from the business.

In short, discretionary earnings are all the monies available to you from the business annually as the owner or seller.

The SDE multiple method also requires a deep analysis of the comparable multiples at which other similar businesses in the industry were sold.

You can apply this method if your business is smaller and usually has under $1 million in annual revenues. You may use the most recent yearly discretionary earnings or an average of the earnings of the last 3-5 years.

Let's look at a quick example:

• You own an engineering business that managed $550,000 in SDE in the past 12 months

• The typical multiple for engineering firms is 5.0x for the seller’s discretionary earnings

Your business's approximate value = Annual SDE x Multiple = $550,000 x 5.0 = $2,750,000.

3. Revenue Multiple Method

The revenue multiple approach attaches the value of a business to its annual net revenue using a market-derived multiplier.

You can also apply the multiplier to the average net revenues of the past 3-5 years.

While the revenue multiple technique is ideal for businesses with robust yearly revenue growth or recurring revenues, it may not provide a clear picture of the value of a business.

Here's an example:

• Business ABZ in the construction supplies industry has an annual revenue of $4.5 million

• Similar businesses in the sector usually sell at a 2.1x revenue multiple. 

The approximate business value for ABZ = Annual revenue x Multiple = $450,000 x 2.1 = $9,450,000.

However, the revenue valuation method doesn't account for customer churn, which can help you tell if your business’s revenue is secure.

You also need to account for expenses. If your business has high revenues and high expenses, using the revenue multiple method may not give an accurate valuation.

Pro Tip: You can use our valuation calculator to estimate your business's worth based on its revenue. Check out the free Exitwise business valuation calculator!

Common Rules of Thumb for Key Industries

When selling your business or company, you'll want to apply a well-researched business value rule of thumb specific to your industry.

Let’s see some common rule of thumb value of business EBITDA multiples based on data from the NYU Stern School of Business:

Technology:

Health:

Real Estate:

Retail:

Limitation of Rules of Thumb Valuation Approach

While ideal for quick and inexpensive surface-level valuations, using rules of thumb to evaluate your business has several disadvantages:

• Limited Applicability or Adaptability: Rule of thumb valuations are based on historical experiences or observations, which may not capture recent market and industry changes. They may only apply well to industries with solidly established standards. 

• Overlooking Unique Characteristics: You can't capture financial factors like profit margins, income stability, growth rates, cash flows, and debt levels with rule of thumb company valuations. They also ignore customer relationships, product or service diversity, market position, brand value, and suitability of the managing team.

• Potential to Misguide or Ruin Negotiations: Great negotiations stem from provable facts and figures, and you may not provide accurate ones when you use rule of thumb methods.

• Overvaluation and Undervaluation Are Common: Since the rule of thumb method uses historical data of other companies, it may not accurately represent your company’s true valuation. While undervaluation means you leave money on the table, overvaluation may scare potential buyers away and make your business stay on the market longer.

How to Use Rule of Thumb Business Valuation for Mergers and Acquisitions

When valuing your business using a rule of thumb for an M&A exit, you'll want to take the steps below:

• Market and Industry Research: Analyze relevant market data for your industry to see the prevailing rule of thumb multiples for various financial metrics for similar businesses.

• Choose Suitable Rules of Thumb: Combine the information from your research and the knowledge about your business to choose the most suitable rule of thumb valuation methods.

• Apply the Market-Based Multipliers: Estimate the value of your business by multiplying the selected financial metrics with their corresponding multiples.

• Re-evaluate Your Business Consistently: Get annual appraisals based on the prevailing market-based metrics to track the value. Note and act on aspects that can help maximize business value.

• Consider Unique Characteristics: Learn the strengths of your business and negotiate a fair purchase price based on these and favorable market conditions.

Applying the rule of thumb business valuations can be daunting, especially when you want to factor in the characteristics that give your business a competitive advantage.

Getting a formal valuation from experienced M&A experts is worth the investment. We at Exitwise can help you find the best M&A team to help you value your business accurately and maximize your sale price. Consult with us today!

Frequently Asked Questions (FAQs)

Here are common questions to consider:

Which Multiple Could Be Used for a Basic Business Valuation?

Most appraisers typically use the discretionary earnings multiple for basic valuations of smaller businesses with annual revenue under $1 million.

The EBITDA multiple is typically used for basic valuations of businesses with over $1 million in annual revenue.

When you consult with us at Exitwise, you can find the best M&A experts to help you value your business based on its crucial financial metrics and unique aspects.

How Much is a Business Worth with $1 Million in Profit?

The value of a business with $1 million in profit varies depending on factors such as the industry, unique business characteristics, current market conditions, and stability of earnings.

Assuming a net profit multiple of 3.5x and $1 million in net profit, the business would be worth $3.5 million.

However, another business with the same net profit but in a different industry with a net profit multiple of 42.5x would be worth $42.5 million.

How Many Times Revenue Is a Company Worth?

The number of times a business is worth its revenue also depends on various factors, such as the industry, market conditions, the amount of recurring revenue, and the number of revenue streams.

According to NYU Stern data, different industries can have the following revenue multiples:

• Healthcare information and technology: 5.29x

• Healthcare support services: 0.61x

• Real estate investment trusts: 11.49x

• Real estate development: 4.38x

• Transportation: 1.68x

• Trucking: 1.81x

Conclusion

When you use a rule of thumb business valuation, you can have a rough idea of how much your business could be worth. However, such valuation methods do not capture the total value because they may overlook your business's unique characteristics.

You would have to work with an M&A team to help you value your business accurately using the right valuation methods and considering its strengths.

We can help you work with the best M&A experts in your industry, such as accountants, attorneys, business appraisers, brokers, investment bankers, and wealth advisors. Book a chat with our Exitwise team today to achieve the exit you’ve always envisioned!