Rule of Thumb Business Valuation: What You Need To Know - Tolj Commercial (2024)

As a commercial real estate advisor who often consults with small business owners, I’m regularly asked – 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 aback-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 commonrules of thumb for business valuation, when they may be useful, and why it pays to invest in a professional appraisal.

Key Takeaways

  • Rules of thumbcan provide a roughballpark valuation rangefor small businesses but have limitations in accuracy.
  • Common rules of thumb focus on multiples ofrevenue, earnings (EBITDA), ordiscretionary 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, 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 popularshortcuts 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 annualEBITDA (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?

Rule of Thumb Business Valuation: What You Need To Know - Tolj Commercial (1)

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 valuationrules 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.

Rule of Thumb Business Valuation: What You Need To Know - Tolj Commercial (2)

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!

Frequently Asked Questions

How to value a business based on revenue?

The revenue multiple is the key factor in determining a company’s value. To calculate the times-revenue, divide the selling price by the company’s revenue from the past 12 months. This ratio reveals how much a buyer was willing to pay for the business, expressed as a multiple of annual revenue. A higher multiple indicates a more valuable company in the buyer’s eyes.

What is a good rule of thumb for valuing my manufacturing business?

For small to midsize manufacturing firms, 2-4X EBITDA or 20-40% of annual revenue is often used by business brokers to estimate value. However, the most prudent approach is hiring an accredited appraiser.

How much does a formal valuation report cost?

Expect to invest around $3,000-$5,000 for a thorough independent valuation. Worth it for the detailed analysis and credibility with potential buyers.

Is a rule-of-thumb valuation enough to get bank financing?

Lenders usually require substantiated valuations from a qualified professional appraiser to secure financing against a business.

What affects business value beyond earnings?

Sustainability of income, growth potential, assets like real estate and receivables, owner involvement, and local market competition all impact value.

Should I use a rule of thumb valuation when listing my business for sale?

Relying solely on a rule of thumb asking price leaves you anchoring negotiations with no factual support. Price within range of recent industry sales and justify based on performance metrics.

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.

Rule of Thumb Business Valuation: What You Need To Know - Tolj Commercial (2024)

FAQs

Rule of Thumb Business Valuation: What You Need To Know - Tolj Commercial? ›

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.

What is the rule of thumb for business valuation? ›

For valuation purposes, a rule of thumb involves applying an industry-specific multiple to an economic benefit, such as business revenue or discretionary cash flow. For example: A businesses' goodwill may be worth 2.0x discretionary cash flow; or.

What is the formula for valuing my business? ›

To accurately ascertain a business's value efficiently, calculate its total liabilities and subtract that figure from the sum of all assets—the resulting number is known as book value. This approach to calculating company worth takes into account both existing assets and any outstanding liabilities.

How do you evaluate commercial value? ›

There are a number of ways to determine the market value of your business.
  1. Tally the value of assets. Add up the value of everything the business owns, including all equipment and inventory. ...
  2. Base it on revenue. ...
  3. Use earnings multiples. ...
  4. Do a discounted cash-flow analysis. ...
  5. Go beyond financial formulas.

How to calculate business valuation like Shark Tank? ›

You already know that when the entrepreneurs ask for their desired investment, they've placed a value on their company. For example, asking $100,000 for a 10% stake in the company implies a $1 million valuation ($100k/10% = $1M).

How much is a business worth with $2 million in 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).

How many times gross revenue is a business worth? ›

The Revenue Multiple (times revenue) Method

A venture that earns $1 million per year in revenue, for example, could have a multiple of 2 or 3 applied to it, resulting in a $2 or $3 million valuation. Another business might earn just $500,000 per year and earn a multiple of 0.5, yielding a valuation of $250,000.

How do I calculate the value of a commercial property? ›

The formula used to calculate the value of a commercial property using the cost approach is:
  1. Property Value = Replacement Cost – Depreciation + Land Value.
  2. Property Value = Net Operating Income / Capitalization Rate.
  3. Gross Rent Multiplier = Sales Price / Annual Gross Rents.
Jun 1, 2021

How do you appraise the value of a commercial building? ›

The three methods for appraising a property's value are the sales comparison approach, the income capitalization approach, and the cost approach. Appraisers may use some combination of all three methods, and may also factor in other information such as market trends, location, risks, and development potential.

How to value a business quickly? ›

A less sophisticated but still popular way to determine a company's potential value quickly is to multiply the current sales or revenue of a company by a multiple "score." For example, a company with $200K in annual sales and a multiple of 5 would be worth $1 million.

How much is a business worth with $3 million in sales? ›

Main Street Deals (Sub $3m Revenue)

Companies with under $3m in sales will typically sell for 2.5 – 3.5 X their discretionary earnings (total cash the owner could take out of the company). Smaller companies that are even more owner-reliant will even be lower than that.

Is there a way to find out what a business is worth? ›

The formula is quite simple: business value equals assets minus liabilities. Your business assets include anything that has value that can be converted to cash, like real estate, equipment or inventory. Liabilities include business debts, like a commercial mortgage or bank loan taken out to purchase capital equipment.

How to calculate the valuation? ›

The valuation of a company based on the revenue is calculated by using the company's total revenue before subtracting operating expenses and multiplying it by an industry multiple. The industry multiple is an average of what companies usually sell for in the given industry.

What is the 1% rule for business? ›

The Main Idea. The "1% Rule" is if you can just consistently and persistently be 1% better at what you do each day, over the course of a year or a decade you will make significant progress.

How much is a typical business valuation? ›

A standard business valuation, especially those for small businesses with limited complexity, will cost between $2000 and $10,000. But in some complex cases, they can cost up to $100,000.

What are the requirements for business valuation? ›

The following documents are necessary to provide an accurate valuation: profit and loss statements, balance sheets and tax returns for the last four to five years; interim profit and loss statements and balance sheets for the current year; copies of any forecasts or projections.

What is the most common way of valuing a small business? ›

Methods for calculating your business's valuation

The two most common are the multiples method and the discounted cash flow (DCF) method.

Top Articles
Latest Posts
Article information

Author: Merrill Bechtelar CPA

Last Updated:

Views: 6564

Rating: 5 / 5 (50 voted)

Reviews: 81% of readers found this page helpful

Author information

Name: Merrill Bechtelar CPA

Birthday: 1996-05-19

Address: Apt. 114 873 White Lodge, Libbyfurt, CA 93006

Phone: +5983010455207

Job: Legacy Representative

Hobby: Blacksmithing, Urban exploration, Sudoku, Slacklining, Creative writing, Community, Letterboxing

Introduction: My name is Merrill Bechtelar CPA, I am a clean, agreeable, glorious, magnificent, witty, enchanting, comfortable person who loves writing and wants to share my knowledge and understanding with you.