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What's it worth? Featured

6:51am EDT July 19, 2002
When buying a company, how do you know you're not paying too much?

As a seller, how do you know that you are not asking too little or too much? For some, the answer is simple -- use industry rules of thumb. Unfortunately, that's not always the right answer.

What are rules of thumb?
Rules of thumb, also known as industry valuation formulas, are industry specific and widely accepted methods of valuing companies. These formulas are based upon historical transactions and are indicative of the fair market value of companies in a given industry.

As a result, otherwise sophisticated business leaders are often lulled into a false sense of security by relying on standardized valuation methods. Unfortunately, these often result in inaccurate values.

Dangers with rules of thumb
A primary problem with rules of thumb is that it's difficult to know where they originated. Perhaps the common knowledge or the methods in industry journals stem from textbooks or trade organizations.

But where did the standardized formula originate? There's no good answer. As a result, many companies continue to be valued based upon standard formulas that obscure the relevant operating characteristics of the company.

Here's a simplified yet realistic example: A rule of thumb often used by towing services is a multiple of average monthly revenue plus fixed assets. Based upon the rule of thumb, we would conclude that two towing companies with equal monthly revenue and equal fixed assets would be of equal value.

The weakness is clear -- the value is based upon revenue as opposed to earnings after expenses.

Would you really want to pay the same price for a marginally profitable or unprofitable towing company as you would for a highly profitable one? Unfortunately, business owners frequently and unwittingly fall victim to these and more complex inconsistencies by relying on industry valuation formulas.

Another fallacy perpetuated by rules of thumb is that transactions are completed on similar terms. This frequently is not the case. Transactions can result in the immediate transfer of cash, payments of cash over time, exchanges of stock or a wide variety of other possibilities.

Failure to properly evaluate the impact of these terms can prove detrimental to a seller.

One good rule of thumb
When valuing a company, do not rely on rules of thumb. In addition to revenue or expenses, or some combination thereof, a high-quality business valuation must consider:

  • Historical financial trends

  • Industry growth

  • Local and national economic trends

  • Alternative investment choices

  • The company's reputation

  • Management strength

  • Supplier relationships

  • The cost of capital

  • Alternative equity structures

The benefit of relying on a simplistic valuation approach is almost always outweighed by the cost of not completing a meaningful analysis. Do not allow yourself or your company to be short-changed by a shortcut.

Raymond H. H. Dunkle is a CPA with Bober, Markey, Fedorovich & Co. He is one of a few professionals in Northeast Ohio to carry both the Accredited in Business Valuation (ABV) and Certified Valuation Analyst (CVA) credentials. Contact him at (330) 762-9785.