The value of a business is equivalent to the sum of its future cash flows. For small businesses, the best way to calculate this is using the PE multiple method, as we discussed in our second video in this series.
But how do you decide what multiple to use? There are basic principles to guide us - things like the size of the business and the industry it is in. Comparables can also be very useful, as we saw in the last video.
But some industries have specific "Rules of Thumb" that provide a lot of guidance in the valuation of businesses in that sector.
"Rules of Thumb" are valuation formulae based on the PE multiple approach, but with specific details about the range and type of multiple to use in a given industry.
In industries where rules of thumb are widely accepted, they are very valuable and should be followed. In other industries, rules of thumb are just guidelines that provide another data point in addition to the general principles.
This video explains what rules of thumb are, and how to use them in the valuation of a small business.
One of the first examples of business valuation we looked at in this series was liquor stores in the United States. In this industry there is a rule of thumb stating that the business should be valued by this formula:
(0.4 to 0.5 x Revenue) + Inventory
This rule dictates the range of multiple to use in this industry (0.4 to 0.5), it specifies that this should be a multiple of revenue (not net profit, SDE, EBITDA or any of the other types of earnings we discussed in the first video), and it also specifies that a category of assets (the inventory) should be added to this at the end.
Many other industries use rules of thumb for business valuation. Small web-based businesses ranging from small e-commerce stores to affiliate marketing businesses all tend to sell for within the same multiple range, which is listed on the Empire Flippers website:
20-40 x Monthly Net Profit
This is the equivalent of 1.67 to 3.33 x annual net profit. Although every business is different, these businesses have enough in common with each other that they can all be reduced down to the same formula to give a valuation range.
Like all businesses, the exact valuation within this range will depend on the unique characteristics of the business. But this rule of thumb provides the guide to the range in which the value should be, and it is stuck to fairly closely in this industry. So in this industry this rule of thumb is important, because it would be difficult to justify a valuation outside of this range.
At the other end of the scale, businesses that hold a lot of assets in real estate also tend to have rules of thumb that apply to their valuations. For example, care homes (nursing homes) in the UK sell for 7-11 x EBITDA. Freehold pubs in the UK tend to sell for 5-9 x EBITDA. In the US small hotels sell for 8-11 x EBITDA and B&Bs sell for 8-9 x SDE. These rules of thumb are based on a multiple of earnings (EBITDA or SDE as the case may be), and they include the property and assets of the business.
Valuation Rule of Thumb Databases
In the United States there are some very comprehensive databases of rules of thumb, the largest of which is the Business Reference Guide. The rules of thumb in these publications cover almost every industry sector, and often include several different rules of thumb for each sector.
For example, accountancy practices (CPAs in the US) have several rules of thumb listed:
1.0-1.25 x Revenue + Inventory
1.8-3.0 x SDE + Inventory
2.2 x EBITDA
2.0 x EBIT
And most other industries are the same: they have multiple rules for each. Rules of thumb are the raison d'etre of these publications, and they create rules on top of rules on top of rules. This is not always helpful. What is really important is knowing the rule of thumb (if any) that is widely accepted in a particular field. For accountancy practices it is the first rule above (1 to 1.25 x Revenue) that is most widely accepted in this industry (and often without the addition of inventory, which is not usually substantial in this sector). The rest of the rules are just useful cross-checks for the valuation range.
Rules of Thumb are valuation formulae based on the PE Multiple approach, but with very specific details about the range and type of multiple to use for a given sector. Rules of Thumb exist in almost every industry – especially in the United States – but how important they are in the valuation process varies a lot by industry.
In some industries there will be a key Rule of Thumb that is widely accepted as the gold-standard valuation method. In other industries they aren’t very important; they merely provide additional data points for the valuation range. But this range will be more dependent on the core principles of business valuation that we’ve already discussed, and the available comparable data.