Rules of Thumb make the business valuation process easier because we humans need mental shortcuts for everything.
These mental shortcuts of rules of thumb make our life so much easier.
Rule of Thumb is an approximate method for doing something.
It is generally based on experience and common sense rather than theories. They are not scientifically accurate but roughly correct.
Rule of Thumbs is important in Business Industry. They can come in handy to make the business valuation process less time-consuming and cost-effective.
Why do we need Rules of Thumb for Business Valuation?
Business Valuation is a process of determination of the market value and evaluation of one's business.
To calculate one's business valuation, all the assets, capital structure, potential earning prospects, etc need to be analyzed.
Valuation of one's business can be quite expensive because of the time and manpower it needs to do the analysis.
Rule of Thumbs are shortcuts and an easy way to evaluate one's business. They can save us both time and money.
Common Rules of Thumb for Business Valuation
In some industries, the Rule of Thumbs is more important than others.
We have many rules of Thumb available at hand to determine the total worth of a business but the common two are
- Multiple principle to the discretionary earnings of the business
- Percentage principle to annual gross revenue of the business
1st Rule of Thumb: Multiple Principle to the Discretionary Earnings of the Business
Using this Rule of Thumb method, we can find the business value of a company by multiplying the Discretionary earnings with a valuation multiple.
Valuation Multiple is chosen based on different factors like a number of businesses, industry, market, and owner preferences.
"Discretionary Earnings = Total Earnings of a business/year - Necessary Expenses/year"
For example,
Multiple methods are particularly suited for businesses whose purchases are driven by both economic and lifestyle conditions.
2nd Rule of Thumb: Percentage Principle to Annual Gross Revenue of the Business
This Rule of Thumb is less accurate when compared to the Multiple Principle for business valuation.
In this method, we just approximately multiply the percentage of the annual sales or gross revenue to calculate the worth of our business.
" Annual Gross Revenue/Sales = Sum of all the sales of a business/Year"
For example, Textile Industry with a proper license is worth about 40% of annual gross income. If it's total sales/ gross income is $100,000, then the business worth based on this rule of thumb will be $400,000
Other Rules of Thumbs for Business Valuation
1. By Comparing Businesses
This rule of thumb is popular recently. It will give us a realistic value of our business by comparing it with similar sold businesses.
The Data for comparison is available online. We can also use the help of business brokers for the same.
2. Using Asset-Value of the Business
One can use this rule of thumb to get a clearer picture of their business quickly. In this method, First, we have to calculate the value of all tangible assets.
Secondly, we have to estimate intangible assets' value by getting professional help.
The only disadvantage of this rule of thumb is that it doesn't reflect the value of the business's earning potential.
3. Using Financial Statements
We can also evaluate our business using our company's past three years financial statements.
Firstly, we should gather the past three years' records, an income statement, a cash flow statement and a balance sheet.
Once the Financial statements are ready, we have to work with a professional accountant. A professional will be able to convert the financial statements into SDE (Seller's discretionary earnings.
Conclusion
As we can see in this article, business valuation can be expensive and time-consuming. Using several rules of thumb, we can evaluate our business for sale easily.
Combining several business valuation methods and rules of thumb, one can gain an accurate appraisal.
While Rules of Thumb are easily available, you might always want to get the best advice from experts if you have the necessary time and resources.
