Business Valuation, Company Valuation
It seems that almost everyone has heard a “rule of thumb” for valuing their business. Maybe you learned it in a trade magazine, at an industry conference, or heard it from a friend or colleague.
Some “rules” that I’ve heard include:
Let me be clear…“Rules of Thumb” are garbage. If you’re using one to value your business, you’re in left field. Here’s why:
Company A
Let’s assume Company A has been in business for 35 years. It’s a manufacturing facility with long-term contractual based revenue. Total annual revenues are approximately $2 million and compiled from a customer base of 40 customers. Annual cash flow is $350,000 with margins that have been steadily increasing year-to-year due to the implementation of new technology.
Company B
Let’s assume Company B started last year in the same industry as Company A. Company B secured one large customer which paid them $2 million in revenue. However, that’s Company B’s only customer and there is no contract in place for next year. Company B has numerous product quality issues, but its cash flow is the same as Company A ($350,000). Company B also has a manual process and needs to invest in technology in order to correct its product quality issues.
Would you pay the same price to acquire these two companies?
Neither would I! They are completely different. Company A is stable and growing with low risk. It has a track record of success, increasing margins, and a diversified customer base. Company B is an infant that got lucky in year 1. It only has one customer, has product quality issues, and requires significant capital investment.
No intelligent buyer would pay the same price for Company A and Company B.
So, what happens when we apply the rules of thumb (above) to these two companies?
“Revenue Rule of Thumb” (1.5 times revenue)
“Cash Flow Rule of Thumb”
- Company A’s cash flow of $350,000 times 3 means Company A is worth $1.05 million
We know these companies aren’t worth the same amount. So, why do the rules of thumb value them the same? Are they worth $3 million, or $1 million? Which rule is right? Is there really a rule?
I said it before and I’ll say it again, “rules of thumb” are garbage. There is no such thing as a rule of thumb for valuing a business. Their flaws are numerous; starting with those demonstrated here.
There are rules to valuing businesses; they’re just not as simple as those stated above. They’re complex theories that require professional application.
Our independent, certified, third party, accredited valuation advisors are well versed in business valuation theory and adhere closely to these standards.
Why do I need a certified professional’s opinion?
Consider standing in front of an educated buyer that holds the keys to your retirement when the buyer asks, “How did you come up with your asking price?” You respond, “I just multiplied my revenue by 1.5 or my cash flow by 3.” How will they respond? Will they respond? Or, will they just walk out the door?
Consider the IRS or the tax courts asking the same question? How will they respond?
How differently might these individuals respond to the answer, “I hired River’s Edge Alliance Group’s independent, certified, third party, valuation experts to opine to a value for my business. Here’s a copy of their analysis, report and findings.”
For more information about our valuation products and services please contact us or fill out the informational box to the right and we will contact you. Thank you!
Learn more about the Asset, Income and Market Approaches to value.
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