Rules of Thumb Valuation Methods

Many people are convinced that there are some quick rules of thumb that could determine the value of a business. Some of these rules of thumb state, for example, that an insurance agency is worth 1.5 times annual commissions, or that a chemical manufacturing company is worth 6 times its EBIT. These formulas may indeed be fair averages, but they give very little help in determining the value of a particular business.

The problem with rule of thumb formulas is that they are statistically derived from the sale of many businesses of each type. That is, an organization might compile statistics on perhaps 50 chemical manufacturers that were sold over a three-year period. They will then average all the selling prices and calculate that the average chemical company sold for an amount equivalent 6 times EBIT. The rule of thumb is thus created. However, some of those companies may have sold for 2 times EBIT, while other for 7 or 8 times EBIT.

The business with expenses and profits that are right on target with industry averages may well sell for a price in line with the rule of thumb formula. Others will vary.

Rule of thumb approaches tend to work in two situations: One is in industries that are rapidly undergoing consolidation, especially if the rolled up companies are being taken public.  In the late 1990s and early 2000’s, for example, internet service providers (ISPs) were bought and sold based on number of subscribers or subscriber revenues.  The other situation in which rules of thumb work well is in acquisitions where the cost structure of the acquired company is almost irrelevant to the acquirer. An example is the payroll industry. When a large payroll processor acquires a small operation, the percentage of revenues spent on labor, software, rent, etc. becomes irrelevant as the customers are switched to the larger processors software and systems.

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