The Rules of Thumb for Valuing a Business

A common misconception among many businesses is that their owners only ought to know their company’s value once they are looking to sell it. And this is why many businesses end up getting less than what they desire in terms of results. Many times business owners are too late to realise the importance of valuing their business. Valuing a business isn't just a process for those who are ready to sell - it's a fundamental step that any tactful business owner should consider.

This article aims to demystify the process of business valuation and emphasise its significance beyond the context of selling your business. We’ll take a look at different methods of business valuation, including a 'rule of thumb' approach, which is the most simplified process for those considering selling their business.

Importance of valuing a business

First off, what does valuing a business mean? A business valuation is the process of determining the financial worth of a company. It involves factors from financial status, market position, earnings, and growth potential. It’s a comprehensive assessment that helps establish a fair value of the business which can be used in various contexts.

The importance of valuing a business goes beyond just wanting to sell a business. It helps business owners make informed decisions about potential investments, mergers, acquisitions, and other opportunities. Regularly evaluating a business can also help in keeping business owners informed of their company's financial health, detect potential issues before it happens, and even identify areas for improvement or expansion.

As a business owner, if you’re planning to sell your business then a business valuation should be at the very start of your process. It’s not just about putting a price tag on your business but understanding your business’s worth, its place in the market, its potential for future growth, and increasing the buyer’s confidence in the selling process.

Different methods for valuing a business

Each business owner or investor has different methods of valuing their business - some would even seek professional services from certified accountants, business valuation companies or business brokers to value it for them. There are several methods to value a business, each with its own pros and cons, and it depends on the nature, size and industry of the business. Often, multiple methods are used in conjunction to provide a more comprehensive valuation.

Some of the most common methods are:

Asset-based valuation: evaluates the business based on the net value of its assets. It sums up the values of all tangible and intangible assets and then subtracts the total liabilities.

Income-based valuation: evaluates the business's ability to generate a profit using Discounted Cash Flow (DCF) analysis and Capitalisation of Earnings.

Market-based valuation: values a business by comparing it to similar businesses that have recently been sold.

Book value: based on the net value of the business's assets as recorded in the financial statements, minus the liabilities.

Rule of Thumb valuation: though not exactly accurate, this quickly estimates the value of a business. Let’s take a look at it further below.

Rule of thumb business valuation

The rule of thumb is a quick and simple business valuation method that is based on common sense and experience. It takes an estimate of the business value using industry-standard multiples applied to a certain financial metric. It is a general principle that is regarded as approximately accurate but not meant to be scientifically correct.

For example, if you're operating a cafe, an industry-standard multiple might be 0.3 to 0.5 times annual revenue. If you're using a revenue multiple, you'll need your total sales for the most recent year—let's assume your cafe made $500,000 in revenue last year. Multiply your chosen financial metric by the industry multiple. In this case, if you use a multiple of 0.4 times annual revenue, you'd calculate $500,000 times 0.4 = $200,000.

So, using this rule of thumb method, the estimated valuation for your cafe business would be around $200,000.

The main benefit of the ‘rule of thumb’ valuation is that it’s simple to do and provides you with a ballpark figure. It doesn't require extensive financial analysis or forecasting, making it more accessible and easier to understand for those without a financial background. This can be particularly useful for small to medium-sized businesses, who may not have the resources or time to conduct a comprehensive valuation.

How to precisely value a business

While the rule of thumb valuation can provide a quick estimate of a business's worth, it's often more beneficial to seek a precise and more personalised valuation of your business as it usually involves a more comprehensive analysis of each aspect of the business.

Professional business brokers can provide businesses with a personalised valuation. Not only do they possess the necessary technical skills and understanding of financial metrics, but also have the experience to evaluate more nuanced aspects of a business, combined with their years of experience in the industry of buying and selling businesses. Furthermore, they can leverage their knowledge of recent transactions and current trends in your industry to deliver an accurate and fair valuation.

When it comes to selling your business and getting a precise and accurate valuation of your business, there’s no better business broker to work with than the team at Kakapo Business.

Kakapo business brokers have experience in the industry and have a strong understanding of the New Zealand market. Choosing Kakapo not only provides you with a precise and fair business valuation but is also dedicated to ensuring their clients get the best service from start to finish with the business selling process.

Want to know how much your business is worth? Contact Kakapo today and get a free market appraisal of your business.