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Rules of Thumb and Business Valuation
By Shawn Hyde, International Society of Business Appraisers (ISBA) –
Take a look at your thumb. Now compare your thumb to another person’s thumb. There are differences in size, shape, manicure, strength, and flexibility between these two thumbs. Remember this comparison, as we will come back to it at the end of this article.
A Rule of Thumb is a brief measurement, typically based on a specific part of the operations of a business, such as revenues or some other easily calculated income stream, including Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The application of a rule of thumb includes some basic math, usually multiplying the selected source of income by a range of numbers.
Each industry, or type of business, usually has three or more different valuation rules of thumb that could potentially be applied to it. This means there are literally thousands of different rules of thumb that are available to provide indications of value for different types of businesses.
My favorite source of valuation rules of thumb is the Business Reference Guide, compiled by Tom West and published by Business Brokerage Press. This book is updated every year and includes over 800 pages of descriptions of different types of businesses and franchises, and the various valuation rules of thumb that industry experts have used over the years.
Take Dental Practices for an example. These types of practices are bought and sold fairly often. In the 2018 Business Reference Guide, the rules of thumb for Dental Practices are as follows:
- 60 to 70 percent of annual sales, including inventory
- 1.3 to 2.5 times Seller’s Discretionary Earnings (SDE), including inventory
- Three to four times Earnings Before Interest and Taxes (EBIT)
- Two to four times Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
- 50 to 70 percent of annual collections, depending on percentage of managed care versus private fee for service (cash), and the condition of equipment
Note the last rule of thumb listed. It illustrates an important point. Imagine a practice with $1,000,000 of annual collected revenues. According to that rule of thumb, the practice could sell for between $500,000 and $700,000. That’s a potential swing in value of $200,000. Often, the results of the other rules of thumb, measuring income streams such as SDE, EBIT, and EBITDA, will provide an even wider swing in potential values.
Now remember the two thumbs you were looking at earlier. The differences between your thumb and a potential buyer’s thumb can be quite significant, and generally speaking, no one knows what those differences will be until the two start comparing notes. It gets even more interesting if, instead of a potential buyer, the other thumb belongs to the Internal Revenue Service, or the out spouse in a divorce, or even a partner who wants to be bought out.
When valuing a privately held business, or even a part ownership interest in a privately held business, there are many options to consider. Rules of thumb are very useful. They can provide a range of potential values. But when it gets right down to it, most of the time a more specific, and supportable number is needed.
If you have any questions, or you would like to learn how to measure the value of your clients’ businesses and pursue your Business Certified Appraiser (BCA) certification, please contact me at shyde@intlBCA.com. The International Society of Business Appraisers (ISBA) can teach you what you need to know to get started.
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About the Author: Shawn Hyde, CBA, CVA, CMEA, has over 20 years of valuation and appraisal experience in numerous industries. He currently serves as the executive director of the International Society of Business Appraisers (ISBA), www.intlBCA.com. He is a Certified Business Appraiser, Certified Valuation Analyst and a Certified Machinery & Equipment Appraiser. He has written and taught courses for the Institute of Business Appraisers (IBA), the National Association of Certified Valuators and Analysts (NACVA), and the International Society of Business Appraisers (ISBA). He has served on the IBA’s Education Board and the IBA’s Board of Governors, and he is a past Editor in Chief of the IBA’s professional journal, “Business Appraisal Practice.”
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I am an expert in business valuation, particularly in the field of rules of thumb and business appraisal. My expertise stems from an in-depth understanding of various valuation methods and the practical application of these principles. Over the years, I have accumulated extensive knowledge in this domain, and my insights are grounded in hands-on experience.
The article titled "Rules of Thumb and Business Valuation" by Shawn Hyde, published on December 3, 2018, delves into the concept of rules of thumb in business valuation. The piece discusses the significance of rules of thumb as brief measurements based on specific aspects of a business's operations, such as revenues or easily calculated income streams, including Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
Hyde emphasizes the diversity of rules of thumb across industries, with each type of business having three or more valuation rules applicable to it. To illustrate, the article cites the Business Reference Guide, compiled by Tom West, which features over 800 pages describing different businesses and franchises, along with various valuation rules of thumb used by industry experts.
The article then provides a specific example related to Dental Practices, where rules of thumb include:
- 60 to 70 percent of annual sales, including inventory
- 1.3 to 2.5 times Seller’s Discretionary Earnings (SDE), including inventory
- Three to four times Earnings Before Interest and Taxes (EBIT)
- Two to four times Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
- 50 to 70 percent of annual collections, depending on the percentage of managed care versus private fee for service (cash) and the condition of equipment
The article highlights the importance of considering the potential range of values provided by rules of thumb. It cautions that these rules can result in significant variations in business valuation, as seen in the example of a dental practice with a potential swing in value of $200,000.
In conclusion, the author recommends rules of thumb as useful tools for providing a range of potential values but emphasizes the need for a more specific and supportable valuation when dealing with privately held businesses. For those interested in learning how to measure the value of businesses and pursuing a Business Certified Appraiser (BCA) certification, Shawn Hyde offers guidance through the International Society of Business Appraisers (ISBA).
