September 23, 2024
Valuing small and medium-sized businesses can be complex, but there are practical rules of thumb that can provide a ballpark estimate. While some situations demand a formal, documented business valuation, the focus here is on widely accepted informal methods that offer quick approximations.
These guidelines are based on expert opinions and data from hundreds of completed transactions reported in national databases.
Two prevalent rules of thumb for estimating business value include: (1) applying a multiple to the business’s discretionary earnings, and (2) applying a percentage to the business’s annual gross revenue.
1. The Multiple of Discretionary Earnings Method
This method is generally more precise, valuing a business by applying a multiple to its discretionary earnings. Discretionary earnings represent the total cash generated annually that is available to the owner after accounting for essential operating expenses. They are not equivalent to the profit or loss reported on tax returns, as owners often include expenses that are not strictly necessary for operations.
Privately held businesses typically appraise between one to six times their discretionary earnings, depending on the industry. For example, an HVAC contractor may be valued at 2 to 3.5 times discretionary earnings, a retail gift shop at 2.5 to 3.5 times, home health care businesses at 2 to 4 times, and dry cleaners at 2.5 to 3.5 times. Wholesale distributors generally fall between 2.75 to 3.75 times discretionary earnings. The exact multiple depends on several factors considered by valuation experts.
2. The Percentage of Revenue Method
This less precise approach values a business by applying a percentage to its annual gross revenue. For instance, a full-service restaurant might be worth 30% to 40% of its annual gross revenue, provided it meets average profitability standards for its industry. Similarly, auto service shops might be valued at 30% to 40% of annual revenue, long-haul trucking companies at around 40%, and dry cleaners at 60% to 70%. However, these valuations must still be supported by adequate bottom-line earnings.
These rules of thumb do not account for the value of real estate or inventory. If the business owns real estate, its value should be added to the guideline valuation. Likewise, inventory should be included at cost to determine the total estimated business value.
These simplified methods provide a starting point for estimating business value, though formal appraisals may still be necessary for more accurate assessments.
