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Rule of Thumb Methods
One of the most common approaches to small business valuation is the use of industry rules of thumb. While most financial analysts cringe at the use of these approaches, they do have their place, which I believe to be as adjuncts to other methods.
Rules of thumb typically are based upon gross sales or net sales plus tangible assets. For example, one rule of thumb says that print shops are worth 50% of most recent year's net income plus inventory at cost plus equipment at fair market value. Another says that small weekly newspapers are worth 100% of one year's gross income.
The problem with these and all 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 100 small weekly newspapers that were sold over a two-year period. They will then average all the selling prices and calculate that the average paper sold for 100% of one year's gross income. The rule of thumb is thus created. However, some newspapers may have sold for 5 times one year's gross while other may have sold for 15% of one year's gross.
The rule of thumb averages may be accurate for those businesses whose performances are right about at the average. 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. To apply the rule of thumb to a business that varies significantly from the average is not appropriate.
To illustrate the limitations of rule of thumb formulas, let's look at a common practice used by marketers and demographers. Zip codes are used not only for moving the mail more quickly, but also for a host of analytical purposes, including grouping people demographically by zip code.
Information on the average income within zip codes is available. Let's say that your income is $35,000 per year, and your zip code is 02915. You learn that your income is just about average for that zip. You also learn that the zip code area that borders your own (call it 02916) has an average income level of $46,000. You reason that all you need do is move to the next neighborhood, and your income will rise by $11,000 per year. Of course this won't work. But it does show how statistical information can be misused. This is exactly how rule of thumb formulas are overused. They are worked backward, from the whole group to the individual component.
Nevertheless, industry averages are a good quick and dirty starting point for valuation. Check with your industry associations(s) for rule of thumb formulas for selling a business. Appendix V. contains a source for further information on rule of thumb formulas. Before taking the formula too seriously, though, check to see how closely your firm's financial performance stacks up to the industry averages. Sources to examine industry averages may also be available from your trade association(s). Other sources are listed in appendix V.
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