Beware of Valuation Rules of Thumb
Valuation Rules of Thumb are a common way to estimate the value of a business. Their easy to comprehend and seemingly broadly apply. But reader beware: at best, the represent an average. They do not take into account how a particular company may stack up to peers – and hence can be a very dangerous method to rely on for anything other than reminiscing.
Suppose for a moment that you are considering buying a company and looking at two potential companies. For arguments sake we’ll call it a dental practice. Here are two commonly used “Rules of Thumb” for the dental industry:
- 65% of Gross Revenues
- 2x Net Income
So let’s apply those to the two hypothetical companies below.
Applying the above rules of thumb results in the below valuations.
So how do you reconcile those numbers? Should there be any situation in which a buyer would pay $650k for A and still consider B less valuable? Maybe. But there would have to be some serious problems with B (example: B’s profits are inflated by a one time insurance proceeds?) But simply using a rule of thumb we’d never know.
That Pesky Bell Curve
So here is the next problem – slightly related to what we were getting at above. At best rules of thumb represent an average. And here is what an average looks like in the real world:
The bell curve shows us that, for some companies those rules may (or still may not!) be accurate, but not many are going to be exactly right. Thats because every single company is unique.
Company B above may have all sorts of structural problems that are going to impair value and bring it way down below the middle of the bell curve. Likewise, Company A might have a great recurring revenue stream with a low breakage rate that yields a higher overall valuation.
Simply relying on rules of thumb is a risky proposition. If you find yourself sitting around wondering about your valuation then fire away. But if you actually need to know your value – you know, for something like an actual sale, or preparing for a sale, or as a nest egg for retirement… etc etc- then it’s probably time to talk about an actual valuation by an accredited professional.